
Book . FS 

Copyright ]^^ 

COPYRIGHT DEPOSm 



INTRODUCTION TO ECONOMIC SCIENCE 



THE MACMILLAN COMPANY 

NEW YORK • BOSTON - CHICAGO 
ATLANTA • SAN FRANCISCO 

MACMILLAN & CO., Limited 

LONDON • BOMBAY • CALCUTTA 
MELBOURNK 

THE MACMILLAN CO. OF CANADA, Ltd. 

TOPONTO 



INTRODUCTION 



TO 



ECONOMIC SCIENCE 



BY 

IRVING FISHER 

PROFESSOR OF POLITICAL ECONOMY 
YALE UNIVERSITY 



Neto gorfe 

THE MACMILLAN COMPANY 

1910 

All rights reserved 



^^.<. 






Copyright, 1910, 
By the MACMILLAN COMPANY. 



Set up September, 1910. 



Kotfnoolr iPtess 

J. S. OusMng Co. — Berwick & Smith Cto. 

Norwood, Mass., U.S.A. 



CJCiA273035 



\.: 



To 

THE MEMORY OF MY FRIEND 

AND COLLEAGUE 

PROFESSOR LESTER W. ZARTMAN 



SUMMARY 

Accounting 

Introduction Chapters I-II 

Capital Chapter III 

Income Chapters IV-V 

Capital and Income .... Chapters VI-VII 

Prices 

General Prices Chapters VIII-XIV 

Particular Prices Chapters XV-XVIII 

Rate of Interest Chapters XIX-XXII 

Distribution 

Sources of Income .... Chapters XXIII-XXIV 

Ownership of Income .... Chapters XXV-XXVI 



CONTENTS 

CHAPTER PAGE 

I. Wealth i 

II. Property 21 

III. Capital 35 

IV. Income 54 

V. Addition of Income 67 

VI. Capitalizing Income 91 

VII. Variations of Income in Relation to Capital . iii 

VIII. The Equation of Exchange 132 

IX. Deposit Currency 152 

X. The Equation during Transition Periods . .170 

XI. Influences outside the Equation .... 180 

XII. Outside Influences {Continued') .... 192 

XIII. Operation of Monetary Systems .... 208 

XIV>i Conclusions on Money 225 

XV. Supply and Demand 237 

XVI. The Influences behind Demand .... 254 

XVII. The Influences behind Supply .... 273 

XVIII. Mutually Related Prices 298 

XIX. ^, Interest and Money 307 

XX. Impatience for Income the Basis for Interest . 317 

XXI. Influences on Impatience 327 

XXII. The Determination of the Rate of Interest . 340 

XXIII. Rent 358 

XXIV. Wages 373 

XXV. Opulence and Poverty 384 

XXVI. Wealth and Welfare 412 



IX 



CHAPTER I 

WEALTH 

§ I. Definition of Economics and of Wealth 

Economic Science, or, as it is often called, PoKtical Econ- 
omy or Economics, may be most simply defined as the 
Science of Wealth. The purpose of economic science is to 
show the nature of wealth ; the relation of wealth to human 
wants, and to the satisfaction of those wants; the forms 
of the ownership of wealth ; the method of its accumulation 
and dissipation ; the reasons that some people have so much 
of it and others so little; and the principles that regulate 
its exchange and the prices which result from exchange. 
In a word, everything which concerns wealth in its general 
sense falls within the scope of economic science. 

To most persons the chief interest in the subject lies in 
its practical appKcations to public problems, such as those 
connected with the tariff, trusts, trade-unions, strikes, or 
socialism. These problems suggest that something is wrong 
in the present economic order of society and that there is a 
way to remedy it. Before we can treat of economic dis- 
eases, however, we must first understand the economic 
anatomy and physiology of society ; that is, we must grasp 
the general economic principles which these pubhc questions 
involve. Hence, the study of economic science must precede 
the application of that science to problems of public pohcy. 
In the end the student will reach more satisfactory con- 
clusions if, at the beginning, he will put aside all thought 
of such applications, and cease to count himself a free trader 
or a protectionist, a monometallist or bimetallist, an indi- 
vidualist or a socialist, or indeed, any other kind of partisan. 



2 ELEMENTS OF ECONOMIC SCIENCE 

We must, then, in the first place, distinguish economic 
science from its applications to public problems; but, in 
the second place, we must likewise distinguish it from its 
applications to private problems. Economics does not 
concern itself with teaching men how to become rich ; nor 
does a practical skill in the art of becoming rich 
imply, necessarily, a sound knowledge of economics. Eco- 
nomics, it is true, is the theory of business ; and business the 
practice of economics. But, though they are not in the 
least conflicting, — indeed, to some extent mutually helpful, 
— they are nevertheless totally different. Some of the 
wildest economic theories have originated among success- 
ful financiers. Men who have been trained in Wall Street 
are often the most sadly in need of elementary instruction 
in economics. This is so because the very matters with 
which people have longest been farnihar are frequently the 
ones which they have been least disposed to analyze. In 
business theory, no less than in the theory of pubKc prob- 
blems, men take too much for granted. 

Our first rule, then, in approaching the study of economics 
is to take nothing for granted. It is quite as important to 
be careful in defining familiar terms, such as ^'prices" and 
*' wages," as in explaining unfamihar ones, such as "index 
numbers" and "marginal desirabihty." 

Having indicated Wealth as the subject matter of Eco- 
nomics, the question at once arises : What is Wealth ? B}'' 
Wealth (in its most general sense) is meant material objects 
owned by human beings} Any single such object is an 
article of wealth, or an instrument. In common parlance, 

1 Every writer may define a term as he pleases, except that he should jus- 
tify his definition in one or both of two ways : (i) by showing that it accords 
with common practice; and (2) by showing that it leads to useful results. 
The above definition of wealth meets both of these requirements. It agrees 
substantially with the usual understanding of business men, and (although 
it departs from the practice of some economists) it leads to a consistent and 
systematic development of the science. 

Some economists add to the definition that an object, to be Wealth, must 



WEALTH 3 

''wealth" is often opposed to '' poverty," the contrast being 
between a large amount of wealth and a small amount ; pre- 
cisely as in common parlance " heat " is opposed to ''cold," 
the contrast being between a large degree of heat and a small 
degree. But just as in physics ice is regarded as having 
some degree of heat, so in economics a poor man is regarded 
as having some degree of wealth. 

Wealth, then, includes all those parts of the material 
universe that have been appropriated to the uses of man- 
kind. It does not include the sun, moon, or stars, for no 
man owns them. It is confined to this little planet of ours, 
and only to certain parts of that ; namely, the appropriated 
sections of its surface and the appropriated objects upon it. 

§ 2. Distinction between Money and Wealth 

One of the first warnings needed by the beginner is that 
he avoid the common confusion of wealth with money. 
Few persons, to be sure, are so naive as to imagine that a 
milHonaire is one who has a million dollars of actual cash 
stored away ; but, because money — or some money — is 

be usefiil; thus defining wealth as "useful material objects owned by 
human beings." But unless a thing is useful no one would care to own it. 
Nothing is owned which is not useful in the sense that its owner hopes to receive 
benefits from it, and it is only in this sense that utility is to be employed as a 
technical term in economics. Therefore, as utility is already implied in owner- 
ship, it need not be mentioned separately in our definition. Other writers omit 
the idea of ownership and simply define Wealth as "useful material objects." 
But this definition includes too much. Rain, wind, clouds, the Gulf Stream, 
the heavenly bodies, especially the sun, from which we derive light, heat, and 
energy, are all useful, but are not appropriated, and so are not wealth as com- 
monly imderstood. Even more objectionable are those definitions of wealth 
which omit the qualification that it must be material ; they do this in order 
to include stocks, bonds, and other property rights, as well as human and 
other services. While it is true that property and services are inseparable 
from wealth, and wealth from them, yet they are not themselves wealth. 
To include wealth, property, and services, all under one term, involves a 
species of triple counting. A railway, a railway share, and a railway trip are 
not three separate items of wealth; they are respectively wealth, a title to 
that wealth, and a service, or benefit, of that wealth. 



4 ELEMENTS OF ECONOMIC SCIENCE 

a kind of wealth, and because the beginner is so accustomed 
to measure all kinds of wealth in terms of money, he some- 
times forgets that not all kinds are money. For an extended 
study of money, we are not yet ready, but as a warning we 
shall here enumerate a few of the most common fallacies 
which beset [the subject. The nature of these fallacies the 
s':udent will understand more fully after they have received 
a more extended treatment. 

First, then, it is sometimes seriously asserted that if one 
man '' makes money," some one else must " lose " it, since 
there is only a fixed stock of money in the world, and it 
seems clear that " whatever money the money-maker gets 
must come out of some one else's pocket." The flaw in 
this reasoning is the assumption that gains in trade are gains 
in actual money, so that in every business transaction only 
one party can be the gainer. If this were true, we might as 
well substitute gambling for agriculture and for manufac- 
turing ; for in gambling the winnings are precisely equal to 
the losses. But as a matter of fact, it is not in order to 
obtain money that people engage in trade, but in order to 
obtain what money will buy, and that is precisely what both 
parties to a normal transaction eventually get. 

Again, some persons have tried to prove that the nations 
of the earth can never pay off their debts because these 
debts amount to more than the existing supply of money. 
This fallacy is due to the fact that debts are merely ex- 
pressed in money. " If we owe money," it is argued, '' we 
can't pay more money than there is." This sounds plausible, 
but a moment's thought wiU show that the same money 
can be, and in fact is, paid over and over again in discharge 
of several different debts ; not to mention that some debts 
are paid without the use of money at all. 

Again, it is sometimes argued that there must be a great 
deal of " water " in the capitalization of the trusts because 
their total capitahzation exceeds all the money in existence. 
But we cannot thus infer that the capital of the trusts is so 



WEALTH 5 

largely fictitious, for capital and money are by no means the 
same thing. A cargo of merchandise is capital, but it is not 
money. 

A few years ago at a meeting of the American Economic 
Association a Western banker expressed the opinion that 
the total amount of money in the world ought to equal the 
total wealth of the world ; else, he suggested, people would 
never be able to pay their debts. He explained that in the 
United States there were twenty dollars of wealth for every 
dollar of money ; and he inferred that therefore there was 
but one chance in twenty of a debtor paying his debts. " I 
will give five dollars," he said, " to any one who can dis- 
prove that statement." When no one accepted the chal- 
lenge, a wag suggested that it was because there was but one 
chance in twenty of getting the promised five dollars ! 

The attempt to equaHze money and wealth by making 
money twenty times as plentiful would, as we shall see later, 
prove absolutely futile. The moment you raised the amount 
of money, the money value of all other forms of wealth 
would rise in proportion, and there would be the same dis- 
crepancy as before. 

A very persistent money fallacy is the notion that some- 
times there is not enough money to do the world's business, 
and that unless the quantity of money is then increased the 
wheels of business will stop or slacken. The fact is, how- 
ever, that any quantity of money, whether large or small, 
will do the world's business as soon as the level of prices is 
properly adjusted to that quantity. In a recent article on 
this subject, an editor of a popular magazine put this fallacy 
into the very title : " There is not enough money in the 
world to do the world's work." He says, " The money is 
not coming out of the ground fast enough to meet the new 
conditions of Hfe." In reality, money is coming out of the 
ground too fast and is having the effect of raising prices. 
This writer contends that the panic of 1907 was due to a 
scarcity of money, whereas the true explanation lies in the 



O ELEMENTS OE ECONOMIC SCIENCE 

fact that gold had been pouring out of the mines for so many- 
years and in such large quantities that men were led to use 
it too freely in speculation, and this inflation of enterprise 
precipitated an economic crash. 

A more subtle form of money fallacy is one which admits 
that money is not identical with wealth, but contends that 
money is an indispensable means of getting wealth. At a 
recent meeting of the American Economic Association a very 
intelligent gentleman asserted that the railways of this 
country could never have been built in the early fifties had 
it not been for the lucky discovery of gold in Cahfornia in 
1849, which provided the " means by which we could pay 
for the construction of the railways." He overlooked the 
fact that the world does not get its wealth by buying it. 
One person may buy from another; but the world as a 
whole does not buy wealth, for the simple reason that there 
would be no one to buy it from. The world gets its railways, 
not by buying them but by building them. What provides 
our railways is not the gold mines but the iron mines. Even 
though there were not a single cent of money in the world, 
it would still be possible to have railways. The gold of 
California enriched those who discovered it, because it en- 
abled them to buy wealth of others ; but it did not provide 
the world with railways any more than Robinson Crusoe's 
discovery of money in the ship provided him with food. If 
money could make the world rich, we should not need to 
wait for gold discoveries. We could make paper money. 
This, in fact, has often been tried. The French people once 
thought they were going to get rich by having the govern- 
ment print unlimited quantities of paper money. Austria, 
Italy, Argentina, Japan, as well as many other countries, 
including the American colonies, and the United States, 
have tried the same experiment with the same results, — no 
real increase in wealth, but simply an increase of the amount 
of money to be exchanged for wealth. 

The idea that money is the essence of wealth gave rise to 



WEALTH 7 

a set of doctrines and practices, called Colbertism or Mer- 
cantilism, the earliest so-called '' school " of poKtical 
economy. Colbert was a distinguished minister under 
Louis XIV of France in the seventeenth century, and a firm 
believer in the theory that, in order to be wealthy, a nation 
must have an abundance of money. His theory became 
known as Mercantilism because it regarded trade between 
nations in the same Kght in which merchants look upon 
their business, — each measuring his prosperity by the 
difference between the amount of money he expends and 
the amount he takes in. To keep money within the country 
Colbert and the Mercantilists advocated the policy now 
known as *' protection." To-day it is generally understood 
that, as between individuals, both nations may gain in an 
exchange transaction ; but the old idea that a nation may 
get rich by selling more than it purchases, and collecting the 
" favorable balance of trade " in money, still forms one of 
the popular bases of protectionism in the United States. 
The more intelligent protectionists give quite different rea- 
sons for a protective tariff, but the old fallacious reason still 
appeals to the multitude, who continue to think that by put- 
ting up a high tariff people are prevented from spending money 
to the foreigner and compelled to keep it in this country. 

In order to avoid money fallacies of the sort we have re- 
ferred to, what the student should realize is that no technical 
term in economics should be used as a basis of reasoning 
without a carefully formulated definition. All catch phrases 
should be avoided. Especially should the student be on his 
guard against every proposition concerning money. " Mak- 
ing money," for instance, is a catch phrase used without any 
definition. Properly speaking, nobody can " make " money 
except the man in the mint. The rest of us may gain wealth, 
but, unless we are counterfeiters, we cannot literally " make '^ 
money. The propositions which are true of money we shall 
state carefully in due time. As yet we are not even prepared 
to define money. 



8 ELEMENTS OF ECONOMIC SCIENCE 

§ 3. Classification of Wealth 

Various kinds of wealth may be distinguished. That 
wealth which consists of owned portions of the earth's sur- 
face is called land; fixed structures upon land are called 
land improvements; and the two together, since they con- 
stitute immovable wealth, are called real estate. All wealth 
which is movable (except man himself) is called commodi- 
ties. There remain, then, human beings themselves, — 
not only " slaves " who are wealth owned by other himian 
beings, but also " freemen " who are wealth owned by 
themselves. 

It is true that in ordinary usage freemen are not counted as 
wealth . And it must be admitted that, if they are wealth, they 
are wealth of a very peculiar sort ; first, because they are not, 
like ordinary wealth, bought and sold; secondly, because 
the owner usually estimates his own value much more highly 
than does any one else; and thirdly, because the owner 
coincides with the thing owned. However, it is perfectly 
logical to make our definition of wealth broad enough to 
include human beings.^ 

1 In order to concede as much as possible to popular usage, the following 
supplementary dej&nition is framed: Wealth (in its narrower sense) consists 
of " material objects owned by human beings and external to the 
owners." This definition obviously includes slaves but not freemen. It corre- 
sponds closely to the popular use of the term, but it is more difficult of applica- 
tion than the wider definition ; for it makes an arbitrary line of demarcation 
between freemen and slaves, when, in fact, there are several intermediate forms, 
such as vassals, indentured servants, long-time apprentices, and men held in 
peonage. A man bound out to service for thirty years is almost indistinguish- 
able from a slave, and if his term of service be long enough, the distinction fades 
away completely. On the other hand, the shorter the term of service the 
nearer does his condition approach freedom. As a matter of fact, almost all 
workers in modern society are bound by contract to some extent and for some 
period of time, even though it be no more than an hour ; and to that extent 
they are not free. In short, there are many degrees of freedom and many 
degrees of slavery, with no fixed line of demarcation. 

The two concepts just mentioned, "wealth in its broad sense" and "wealth 
in its narrow sense, " need cause no confusion. When the simple term "wealth " 
is used, the broad meaning will be understood, and any propositions which 



WEALTH 



There are of course many admissible ways of classifying 
wealth. That which follows seeks to exhibit the principal 
groups into which wealth most naturally falls/ 



Wealth 



Real Estate 



Commodities 



Land 



Land improve- 
ments 



Raw materials 



{Productive land 
Ways of transit 
Building land 

Buildings 
Improvements 

on highways 
Minor 

(Mineral 
Agricultural 
Manufactured 



Finished products 1 Consumable 
j Durable 



Human being I Slaves 
I Free 



It scarcely needs to be stated that these groups are not 
always absolutely distinct. Like all classes of concrete 
things, they merge imperceptibly into each other. For 
this reason the classification is of little importance in scien- 
tific study, except as giving a bird's-eye view of the field of 
economic science. 

§ 4. Measurement of Weath 

Having seen what wealth is and what it is not, and having 
classified it roughly, we shall next examine separately its 



hold true of wealth in this meaning will necessarily hold true of wealth 
in the narrow meaning. Whenever there is occasion to restrict the term, 
we shall make use of the phrase, "wealth in its narrow sense." 

^ The student need not attempt to learn this classification outright. He 
should simply become familiar with its chief divisions, studying its details 
merely as illustrative. It is also advisable that he construct other classifi- 
cations, of which many are possible. 



lO ELEMENTS OF ECONOMIC SCIENCE 

two attributes, materiality and appropriation, devoting the 
remainder of this chapter to the first of these. 

The materiahty of wealth is chiefly important as pro\dd- 
ing a basis for the physical measurement of wealth. Wealth 
is of many kinds, and each kind has its own appropriate 
unit of measurement. Some kinds of wealth are measured 
by weight. This is true, for instance, of coal, iron, beef, 
and in fact of most " commodities." Of units of weight, a 
great diversity have been handed down to us, such as the 
pound avoirdupois, the kilogram, etc. In England, besides 
the avoirdupois pound and the Troy pound, and the apothe- 
cary's weight, there is the pound sterling, used for measuring 
gold coin. This is much smaller than any other pound, 
owing partly to the frequent debasements of coinage that 
have occurred, and partly to the past change from silver to 
gold money. In the United States a dollar of " standard 
gold," or gold which is yo ^^^j i^ ^ ^^^^ ^^ weight, employed 
for measuring gold coin. It is equivalent to 25.8 grains, or 
to TQQ% of a pound avoirdupois, since there are 7000 grains 
in a pound avoirdupois. We can scarcely put too much 
emphasis on the fact that the pound sterling and the dollar 
are units of weight. As units of '' value, ^^ we need not yet 
trouble ourselves about them. 

For m-any articles it is not so convenient to measure by 
weight units as to measure by space units, whether of volume, 
of area, or of length. Thus we have, for volume, milk 
measured by the quart, wheat by the bushel, wood by the 
cord, and gas by the cubic foot ; for areas, we have lumber 
sold by the square foot, and land by the acre. For length, 
we have rope, wire, ribbons, and cloth measured in feet and 
yards. 

Many articles are already in the form of more or less 
definite units. In these cases the measure of their quantity 
is the number of such units. For instance, eggs or oranges 
are measured by their number expressed in dozens. Simi- 
larly, sheets of writing paper are reckoned by the " quire," 



WEALTH II 

pencils and screws by the " gross.'' In such cases the 
article is said to be measured " by number." But " num- 
ber " is by no means peculiar to such cases. All measure- 
ment impHes an abstract number, as well as a concrete unit. 
The only pecuKarity of measurement " by number " is that 
the unit, instead of being one which is applied from the 
outside, as by the yardstick, is one in which the things meas- 
ured happen to be already divided. 

The Enghsh pound avoirdupois is the weight of a part- 
icular piece of platinum kept in London. A great many 
copies of it have been tested by balance, so that they weigh 
almost exactly the same as that pound ; but there is, prop- 
erly speaking, only one standard pound and that is the 
one in London. So also the kilogram is another piece of 
metal kept in Paris. These units, like all units, are arbi- 
trary. The definition of an English yard, for instance, is 
simply an imaginary line drawn between two small dots on 
gold plugs in a particular brass rod in London. 

Having such definitely specified units of measure and a 
knowledge of the num^ber of tim.es that unit is contained in 
any given wealth, the amount of that wealth is fully ex- 
pressed. This assumes that the given wealth is homogeneous, 
so that all parts of it are measurable in the same unit. If 
different qualities have to be distinguished, the amount of 
each quahty requires separate measurement. But the ex- 
istence of a gradation in quality, such as is usually applied 
to real estate, makes it very difficult to measure wealth in 
physical units. A tract of land of loo acres may consist of 
many different qualities of land, and to include all these as 
merely so many acres is a misleading measurement. Or, 
sometimes there is only one article of the particular kind in 
existence, in which the element of comparison is left out of 
the measurement. There is but one Battery Park, one White 
House, one Koh-i-noor diamond, one Rhynd-papyrus. 

The unit of measure of any kind of wealth, therefore, 
when fully expressed, implies a description, not only (i) of 



12 ELEMENTS OF ECONOMIC SCIENCE 

size, but also (2) of quality ; as, for instance, a " pound of 
granulated sugar," It may be necessary to enumerate the 
particular attributes of the wealth under consideration, or 
enough of these attributes to distinguish that species of 
wealth from others with which it might be confused. Thus 
it is often necessary to specify what " grade " or ''brand " 
is meant, as " grade A," ^' Eagle brand," " Lackawanna," 
etc. Sometimes the special variety is denoted by a 
" trademark " or " hall-mark." It is in this way that the 
attributes of particular kinds of wealth enter into the 
consideration of economic science, and not, as some have 
erroneously supposed, as themselves constituting separate 
" immaterial " sorts of wealth. ^' Fertility " is not wealth, 
though " fertile land " is wealth. The " skill " of a me- 
chanic is not wealth, though the skillful mechanic is wealth. 

§ 5. Value and Price 

We have considered articles of wealth as measured sep- 
arately. Each kind has its own special unit, as pounds, 
gallons, or yards. But it is convenient also to measure the 
combined value of aggregations of wealth. This term in- 
troduces the principle of exchange. So much mystery has 
surrounded " value " that we cannot be too careful to obtain 
a correct and clear idea of it at the outset. In the explana- 
tion which follows, the concept of value is made to depend 
on that of price ; that of price, in turn, on that of exchange ; 
and, finally, that of exchange on that of transfer. We must 
begin, therefore, with transfer. 

Wealth is said to be transferred when it changes owners. 
A transfer is a change of ownership. Such a change does not 
necessarily imply a change of place. Ordinarily, of course, 
the transfer of an article is accompanied b)/ change in its 
position, the purchase of tea or sugar being accompanied by 
the physical delivery of these articles across the counter 
from dealer to customer ; but in many cases such a change 



WEALTH 13 

of position does not occur, and in the case of real estate it is 
even impossible. The distinction between change of owner- 
ship and change of position is often overlooked. Exports 
and imports, for instance, mean change of place ; whereas 
international trade means changes of ownership. Some 
wealth may be exported, therefore, without being trans- 
ferred, as when an American going abroad takes his effects 
with him. On the other hand, wealth may be transferred 
without being exported, as when, for example, American 
railroads are transferred in part to foreign ownership, 
though they cannot be exported. Yet we say that exports 
and imports must balance each other when we really mean 
that international trade must balance. 

Transfers may be voluntary or involuntary. Examples of 
involuntary transfers of wealth are : (i) through force and 
fraud of individuals, as in the case of robbery, burglary, or 
embezzlement ; (2) through force of government, as in the 
case of taxes, court fines, and eminent domain. But at 
present we have to do only with voluntary transfers. Vol- 
untary transfers are of two kinds : (i) one-sided transfers 
i.e. gifts and bequests ; and (2) reciprocal transfers, or 
exchanges, which are of most importance for Economics. 

Exchange, then, means the mutual and voluntary transfer 
of wealth between two owners, each transfer being in considera- 
tion of the other. When a certain quantity of wealth of one 
kind is exchanged for a certain quantity of wealth of another 
kind, we may divide either of the two quantities by the 
other and obtain what is called the price of the latter. 
Thus if 200 bushels of wheat are exchanged for 100 ounces 
of silver, the price of the wheat is ^^ or ^ ounce of silver 
per bushel. Contrariwise, the price of silver in terms of 
wheat is f-^-g- or 2 bushels per ounce. Thus there are always 
two prices in any exchange. Practically, however, we 
usually speak only of one, viz. the price in terms of money, 
obtained by dividing the units of money by the units of the 
commodity. 



14 ELEMENTS OF ECONOMIC SCIENCE 

While it is true that any two kinds of wealth may be ex- 
changed, some kinds of wealth are more acceptable in 
exchange than others. Money primarily means wealth 
which is generally acceptable in exchange. And here for the 
first time we reach a definition of money. In other words, 
the fundamental quality of money is its exchangeabihty. 
An exchange in which money does not figure is called barter. 
An exchange in which money doe5 figure is called a purchase 
and sale^ — a purchase for the man who parts with the 
money, a sale for the man who receives it. Originally, all 
exchange was barter, but to-day most exchange is, as we all 
know, purchase and sale. 

In order that there may be a price, it is not necessary that 
the exchange in question shall actually take place. It may 
be only a contemplated exchange. A real estate agent often 
has an *' asking price" ; that is, a price at which he tries to 
sell. This is usually above the price of any actual sale 
which may occur later. In the same way there is often a 
'' bidding price," which is usually below the price of actual 
sale. Hence, the price of actual sale usually lies between 
the price first bid and the price first asked. But it some- 
times happens that the bidder refuses to raise his bidding 
price and the seller refuses to lower his asking price enough 
to bring the two together. In such a case no sale takes place, 
and the only prices are those bid and asked. For many com- 
modities the trade journals report, preferably, the prices of 
actual sale ; but if there has been no sale, the prices bid or 
asked, or both. 

When there is no sale, especially when there is no price 
bid or asked, it is not so easy to answer the question, What 
is the price? Recourse is then had to an ''appraisal" 
which is simply a more or less skillful guess as to what price 
the article could or should bring. Appraising or guessing 
at prices is often very difficult. It frequently has to be em- 
ployed, however, by the government, for assessing taxes 
and customs duties and condemning land; by insurance 



WEALTH 15 

companies for settling claims and adjusting losses; by 
merchants for making up inventories and similar statements ; 
and by statisticians for numerous purposes. In fact, some 
people make a Kving by appraising wealth on which, for one 
purpose or another, a price of some sort must be set. The 
purpose evidently makes a great difference in the appraisal. 
Sometimes we want to know the price for which an article 
could be sold in an immediate forced sale ; sometimes, the 
price it might be expected to bring if a reasonable time were 
allowed; sometimes, the price the owner would probably 
take ; sometim_es, the price a possible purchaser would prob- 
ably give. And these prices may be all different. A family 
portrait may be w^orth a big price to the owner, and yet 
bring next to nothing if sold to strangers. The owner 
would naturally appraise it at a high figure if he wished to 
insure it against fire, but if he should try to borrow money 
on it from a pawnbroker, the appraisal would have to be 
small. 

Consequently, in applying an appraisal, we encounter 
many difficulties because the parties involved usually have 
some interest to serve. When a farmer has land for sale, he 
will hold it at a high price to prospective purchasers, but 
enter it, if the truth must be told, at a low price on the tax 
list. When a fire loss is adjusted, the two conflicting in- 
terests, viz. the " insured "and the '' company," are usually 
represented by two experts who in case of disagreement 
call in a third. 

Having succeeded in obtaining the price of any kind of 
wealth, we may next proceed to compute the value of any 
given quantity of it. A7id the value 0] a given quantity of 
wealth is that quantity multiplied hy the price} Thus, if the 

^ This definition of value departs from the usage of some textbooks, but 
follows closely that of business men and practical statisticians. Economists 
have sometimes confined "price" to what is here called money price and 
applied the term "value" to what is here called price. Other economists 
have used the term "price" in the sense of market price, — w^hat an article 
actually sells for, — and "value" in the sense of appraised price or reasonable 



i6 



ELEMENTS OF ECONOMIC SCIENCE 



price of wheat is f dollars per bushel, then a lot consisting 
of 3000 bushels would have a value of 3000 times f dollars 
or 2000 dollars. In other words, the value of a certain 
quantity of one kind of wealth at a given price is the quan- 
tity of some other kind for which it would be exchanged, if 
the whole quantity were exchanged at the price set. 

The distinctions between quantity, price, and value of 
wealth may be illustrated by an inventory such as the 
following : 



Shoes . . . 
Beef . . . 
Dwelling house 
Wheat . . 



Quantity 



1000 pair 
300 lb. 

I house 
100 bu. 



Pbicb 



4^ bu. per pair 
^ bu. per pound 
10,000 bu. per house 
I bu. per bushel 



Value 



4250 bu. 

60 bu. 

10,000 bu. 

100 bu. 



In the second column are recorded various quantities of 
wealth, measured each in its own special unit ; in the third 
column are the prices of these in terms of wheat ; while in 
the last column are their values, also in terms of wheat. 
The first and last columns of figures represent two different 
ways of measuring wealth. Statistics of wealth, such as 
those published monthly by the Department of Commerce, 
usually give both " quantities " and " values." To trans- 
late from one to the other we always need a price as a go- 
between. 

It is important not to confuse the columns with one 
another. The quantity of beef is totally different from its 
value, and each of these is different from its price. The 
quantity is here measured in pounds of beef, its value in 
bushels oi wheat, while its price is measured in bushels per 
pound. 

price, — what it ought to sell for. Still others have used the term "price" 
in the sense employed in this book, but "value" in the sense of the degree 
of esteem in which an article is held, — what in this book wiU later be called 
"marginal desirability." 



WEALTH 17 

The measurement of wealth in " value " has one great 
advantage over its measurement in " quantity." It 
translates many kinds of wealth into one kind and thus 
enables us to add them all together. This is a very use- 
ful accomplishmxent. To add up the second column is 
quite impossible, because shoes, pounds of beef, houses, and 
bushels of wheat are incommensurable. But the items in 
the third column of the inventory, being expressed in a 
common unit, may be added together, despite their otherwise 
baffling diversity. 

Since prices and values are usually expressed in money, 
the most exchangeable kind of wealth, therefore money may 
be said to bring uniformity of measurement out of diversity. 
In other words it is not only a medium of exchange, but it is 
also a measure oj value. 

Although this reduction to a common measure is a great 
practical convenience, we must not imagine that it gives 
what may be called " the true measure " of wealth. In 
fact, to measure the amount of wealth by its value — i.e. 
its money value — is often misleading. The money value 
of car wheels exported from the United States in one month 
was $12,000, and in a later month, $15,000, from which fact 
we might infer that these exports had increased. But the 
number of car wheels exported in the first of those two 
months was 2200, and in the second only 2100, showing a 
decrease. Likewise, the figures for imports of coffee in 
these periods show a decKne in dollars, despite an increase 
in pounds. It is conceivable that the quantity of every 
article might decrease, and yet, if the prices increased suffi- 
ciently, there would be an apparent increase of wealth when 
there really was nothing of the kind. Such is apt to be the 
case in times of an inflation of the currency. 

Even when we are confessedly trying to measure the 
value of wealth and not its quantity, it is difficult or im- 
possible to find a right way. Imports into the United 
States from Mexico in one year were worth 28 millions 



1 8 ELEMENTS OF ECONOMIC SCIENCE 

of American gold dollars, and ten years later, their value 
was 40 millions, — an increase in value of 42 per cent ; but 
these very same imports measured in Mexican silver dollars 
were 41 millions in the first year and 90 millions in the 
second, — an increase in value of nearly 1 20 per cent. 
These increases do not agree ; yet the American merchant 
reckons value one way, and the Mexican merchant, the other. 
In a sense both are right ; that is to say, both are true 
statements of the value of the articles imported, one of the 
value in gold and the other of the value in silver. If the 
value were measured also in iron, copper, coal, cotton, 
or any other article, we should have many other different 
" values," no two of which would necessarily agree. " The 
value of wealth," therefore, is an incomplete phrase; to be 
definite we should say, " the value of wealth in terms of 
gold," or in terms of some other particular article. Hence 
we cannot use such values for comparing different groups 
of wealth, except under certain conditions, and to a limited 
degree. To compare the wealth values of distant places or 
times, — as America and China, Ancient Rome and Modern 
Italy, or Carnegie and Croesus, — will inevitably give 
conflicting and unsatisfactory results. 

§ 6. Limit of Accuracy in Economic Measurements 

We have learned how the three magnitudes — quantity, 
price, and value of v/ealth — are usually measured, and that 
their measurement is practically a very inaccurate affair. 
Yet in the minds of most persons, even of business men, the 
degree of accuracy attained is exaggerated. Even in the 
measurement of the mere quantities of wealth there are two 
sources of error ; for every such measurement includes, as we 
have seen, two elements : a unit and a number or ratio, as 
the pound, and the number of pounds ; and both the unit 
and the number or ratio may be inaccurate. In modern 
times the first source of error — the unit — is practically 



WEALTH 19 

eliminated. Our units of weight and measure are stand- 
ardized by law, and a pound in California is, for all practical 
purposes, equal to a pound in Connecticut. There is, 
moreover, at Washington a national bureau and a special 
building for preserving and testing standards of measure- 
ment. Different towns have their sealers of weights and 
measures, to prevent error through ignorance or fraud. 
But this fortunate condition of affairs did not always exist. 
The Egyptians are said to have been unable to test their 
units of length to less than i foot in 350. The Roman 
weights were only true to i pound in 5c. And when we go 
back to primitive units, we find that they were very rough 
indeed. A yard was probably originally the length around 
the waist, which naturally was apt to fluctuate considerably. 
So also the distance between the elbow and the end of the 
finger was taken as a unit and called the ell. Fraud was, 
therefore, as easy as it was common. At Bergen, in Norway, 
among other relics of the old Hanseatic League, are the scales 
used for bu3dng and selling fish, with two sorts of weights 
used, one considerably heavier than the other. The heavier 
were used for buying and the fighter for selfing ! Such tam- 
pering with weights and measures is now almost unheard of. 

To-day the chief error lies not in the unit, but in the ratio 
of the quantity of wealth to that unit. In retail trade the 
inaccuracy from this source is very great. If we get our 
apples or potatoes measured correctly within five per cent, 
we are fortunate. Wholesale transactions are more accu- 
rate. Probably the greatest degree of accuracy ever at- 
tained in commercial measurements is on the mint scales 
employed by the federal government in Philadelphia and 
San Francisco. These scales weigh accurately to within 
about one part in ten million. 

Besides these two sources of error in the measurement of 
mere quantity, when we proceed from quantity of wealth to 
value, we introduce still a third source of inaccuracy, viz. 
the price factor by which we multiply the quantity in order 



20 ELEMENTS OF ECONOMIC SCIENCE 

to get the value. This is especially true if the price be 
merely an " appraised " price. The price in an actual sale 
is an absolute fact and cannot be said to have any inaccu- 
racy ; but the price at which we estimate a thing would sell 
under certain conditions is always uncertain. In the case 
of '' staple " articles, i.e. articles regularly on the market, 
a dealer can often appraise correctly within one per cent. 
Real estate in certain parts of the city where sales are active 
can sometimes be appraised correctly within five or ten per 
cent, but in the ^' dead " or out-of-the-way parts of some 
towns, where sales are infrequent, the appraisement becomes 
merely a rough guess. Again, in the country districts, while 
farms in the settled parts of Iowa and Texas can be ap- 
praised within ten or fifteen per cent, in the backward parts 
even an expert's valuation is often proved wrong by more 
than fifty per cent. And where a sale of the article in ques- 
tion is scarcely conceivable, an appraisement is almost out 
of the question. To estimate the value of Yellowstone Park 
is impossible, unless we allow ourselves an enormous range. 
Still wider limits must be allowed when we try to value 
human beings. We can often give a lower Kmit, but seldom 
an upper one. The estimates may vary enormously with 
the point of view It is sometimes said, " If I could buy 
Mr. So-and-so at my valuation and sell him at his, I'd get 
rich." It v/ould be erroneous, however, to conclude, as 
some writers have done, that because we cannot value them 
accurately, public parks or freemen cannot be called wealth.^ 

^ When the slaves in the South became freemen, they ceased to be ap- 
praised as wealth. The result has been somewhat confusing to our census 
statistics. The "Manufacturers' Record" of Baltimore recently issued 
figures showing a sharp drop in the assessed valuations of wealth in the 
South after the war. The inference was drawn that the value of wealth had 
immensely decreased; but a large part of this so-called decrease consisted 
merely in the change of ownership of slaves from their old masters to them- 
selves, and their consequent omission as items of value. Any valuation of 
freemen should exceed that of slaves ; but even on the basis of slave values 
the total value of the human beings in any country is always greatly in excess 
of the total value of all other wealth. 



CHAPTER II 

PROPERTY 

§ I. The Nature of Property 

Our definition of wealth restricts it to concrete material 
objects. According to the definition, wealth has two attri- 
butes : materiality and o^vnership. Its materiality was the 
subject of the preceding chapter ; its ownership will be the 
subject of the present chapter. 

To own wealth is to have a right to the benefits of wealth, 
and before proceeding further with the discussion of owner- 
ship we must consider the " benefits " of wealth. To own 
a loaf of bread means nothing more or less than to have the 
right to eat it, sell it, or otherwise employ it to satisfy 
one's desires. To own a suit of clothes is to have the right 
to wear it. To own a carriage is to have the right to drive 
in it or otherwise utilize it as long as it lasts. To own a plot 
of land means to have the right to use it forever. The real 
objects for which wealth and property exist are the benefits 
which they confer. If some one were to give you a thousand 
dollars on condition that you neither spend them nor give 
them away, or if some one gave you a house on condition that 
you never use it, sell it, rent it, or give it away, you would be 
justified ui refusing it as worthless. 

Benefits are also called the uses or services or work of 
wealth. The last two terms are generally employed when 
the wealth referred to is human beings. Sometimes these 
benefits consist of positive advantages and sometimes of the 
prevention of disadvantages. Benefits, then, mean desirable 



22 ELEMENTS OF ECONOMIC SCIENCE 

events obtained or undesirable events averted by means of 
wealth.^ When a loom changes yarn into cloth, the trans- 
formation is a desirable change due to the loom; it is a 
benefit conferred or performed by the loom. The benefit 
from a plow is the turning up of the soil. The benefits or 
services performed by a bricklayer consist in the laying of 
bricks. The benefits conferred by a fence around a farm 
consist in preventing the cattle from roaming away. The 
dikes in Holland confer the benefit of keeping out the ocean. 
The benefits conferred by a diamond necklace consist in its 
sparkle and the satisfied vanity of the wearer. 

To be desirable an article must confer benefits on the 
owner, but not necessarily on the community at large. For 
instance, the noise of a factory whistle may be a nuisance 
to the community, but as long as it is serviceable to the 
owner of the factory, it is for him a benefit. 

Benefits may be measured just as wealth may be meas- 
ured, although the units of measurement are of course not 
the same. We measure some benefits by number, — as 
when we count the strokes of a printing press. We measure 
other benefits by time, — as when we reckon a laborer's 
work by the number of hours or days that he is engaged in it. 
Some benefits of wealth we measure by the wealth which it 
produces, — as when the work of a coal miner is measured 
by the amount of coal he mines, or when the use of a loom is 
measured by the number of yards of cloth it weaves. 

When we have measured the benefits of wealth, we may 
apply to them the same concepts of transfer, exchange, price, 
and value which, in the last chapter, we appKed to wealth. 
We have seen that wealth may be exchanged. The same 
is true of the benefits of wealth. But when the benefits of 
wealth are exchanged, there is really no new kind of exchange 

* Benefits (or uses) or services must not be confused with the utility (or 
desirability) of those benefits. The benefits are desirable events ; the 
utility is the desirability of those events. "Desirability" is very im- 
portant in economics, but does not concern us until Chapter XVI. 



PROPERTY 23 

taking place. For to exchange wealth is really to exchange 
the benefits of wealth. Under the term '' wealth " we really 
take account of the benefits of wealth. The wealth was the 
thing explicitly mentioned and measured, but its benefits 
were included by implication. 

Opposed to the benefits of wealth are its costs. Costs may 
be called negative benefits. The purpose of wealth is to 
benefit its owner ; that is, to make happen what he desires to 
happen, and to prevent from happening what he does not 
desire to happen. But often wealth can work no benefit 
without en taihng some cost ; that is, preventing what is desir- 
able or occasioning what is undesirable. Whatever wealth 
brings about to the pleasure of the owner is a benefit ; what- 
ever it brings about to his displeasure is a cost. He assumes 
the costs only as a means of securing the benefits. 

As most roses have thorns, so almost every beneficial 
article has its costs. The benefits from a farmer's land are 
measured by the crops which that land produces ; the costs 
it imposes are measured by the labor, trouble, and expense 
of getting the crops. 

The costs of wealth may, of course, be measured, just as its 
benefits are measured, — by number, by time, or other 
appropriate units. 

§ 2. Rights to Benefits of Wealth 

We have said that to own wealth means to have the right 
to its benefits. We have seen what is meant by '' benefits " 
and have next to examine what is meant by " right." 

Rights, in the most general sense, are the liberty, under 
the sanction of the law and society, to enjoy the benefits and 
assume the burdens of wealth. Lawyers generally distin- 
guish between property rights and personal rights, but to the 
economist all rights are proprietary. We have already 
defined wealth in its broad sense as inclusive of persons. 
Consequently personal rights are but rights to personal 



24 ELEMENTS OF ECONOMIC SCIENCE 

wealth, — just as other rights are rights to other wealth. 
Logical convenience is therefore served by comprising under 
the general term of property rights all rights whatsoever. 
Every right, then, is a right to the benefits from wealth, 
whether persons or things. For instance, the right to Hfe, 
liberty, and the pursuit of happiness ; or the right of a hus- 
band over a wife or of a wife over a husband ; or the rights of 
parents over children or of children over parents, — all 
these may be regarded as property rights in the broadest 
sense. It is not often, however, that personal rights will 
need our attention. It is only as property in human beings 
enters into commerce that such rights obtrude themselves. 
When wives were bought and sold, they were thought of as 
wealth; and the rights of husbands were thought of as 
property. 

The benefits to which a right in wealth entitles its pro- 
prietor require time for their occurrence and are either past 
or future. The past and the future are separated by the 
present, which is a mere point of time. The only benefits 
from wealth, which can be owned at this present point of 
time, are future benefits. Past benefits have vanished. 
When a man owns any form of property, he owns a right to 
future benefits. The idea of " futurity " must therefore 
be added to our definition ; so that it shall read : Property 
is the right to future benefits of wealth. But even yet we 
are not quite done with our definition. For the future is 
always uncertain ; no man can ever tell in advance exactly 
how much future benefit he can obtain; he can only take 
the chances and risks involved. We must therefore add to 
our definition the idea of uncertainty. The definition will 
now read : Property is the right to the chance of future benefits 
of wealth. If a man has the right to all the benefits which 
may come in the future from a particular article of wealth, 
he is said to have its complete ownership, or its ownership 
" in fee simple." If he has a right to only some of the 
benefits from a particular article of wealth, he is said to own 



PROPERTY 25 

that wealth partially, or to ''have an interest " in it. When 
two brothers own a farm in partnership, each is a part owner ; 
each has an interest in the farm ; that is, each has a right 
to half of the benefits to be had from the farm. What is 
divided between the two brothers is not the farm, but the 
benefits of the farm. To emphasize this fact the law de- 
scribes each brother's share as an " undivided half interest." 
Property may be measured just as wealth and benefits 
may be measured. For instance, the quantity of property 
in the form of railroad stock is measured by the number of 
shares held. After the quantities of property of different 
kinds are measured, we may apply the same concepts of 
transfer, exchange, price, and value which have already 
been appKed to wealth and the benefits of wealth. And 
just as the exchange of wealth was a disguised exchange of 
the benefits of wealth, so the exchange of services of wealth 
is a disguised exchange of property rights to these benefits. 
In the last analysis, then, the only thing that is ever exchanged 
is property. It is only for the sake of brevity and simphcity 
that we ever speak in any other terms. It would evidently 
be pedantic for a man selling wheat to insist always that he 
was not selhng " wheat," but only the " right to possible 
future benefits from wheat." 

§ 3. The Relation between Wealth and Property 

We have thus far considered three very important and 
fundamental concepts : wealth, benefits, and property. A 
convenient collective term for all of them is ^' goods." 

Wealth and property are only present representatives of 
future benefits and costs. Wealth being the means, and 
property the right, to those future benefits (and costs) , wealth 
and property may be said to be coextensive. There cannot 
be wealth without property, nor property without wealth. 
This follows from the definitions given. Wealth was defined 
as som^ething owned ; this implies property. Property was 



26 ELEMENTS OF ECONOMIC SCIENCE 

defined as the right to wealth; this implies wealth. In 
specific cases we can readily see the correspondence. In 
fact, in cases where wealth is owned "in fee simple" or com- 
pletely, the correspondence is altogether too clear ; so clear 
that in ordinary parlance the two terms, wealth and prop- 
erty, become confused, as when speaking of a piece of wealth, 
in the form, say, of land, we call it a '' piece of property." 
On the other hand, where the ownership is minutely 
subdivided, the wealth and the property rights to that 
wealth become so dissociated in our minds that we are apt 
to fall into the opposite error, and completely lose sight of 
the connection. For instance, when railway shares are sold 
in Wall Street, the investor rarely thinks of those shares as 
connected with any actual wealth. All that he sees are the 
engraved certificates of his property rights ; he has no visual 
picture of the railway. Sometimes the rights are still 
further separated from the thing to which the rights relate, — 
so far that people are unaware that there is anything behind 
the rights at all, and delude themselves with the notion that 
there need not be anything behind them. A government 
bond, for instance, is often regarded as a kind of property 
behind which there is no wealth. But if you examine it, you 
will find that the wealth of the entire community is behind 
this property ; for it is out of this wealth, by means of taxa- 
tion, that the bond must be paid. For cities, in fact, there 
is usually a legal debt limit expressed in terms of the value 
of taxable wealth to insure the creditors that there shall 
always be sufficient real wealth behind the city bonds to make 
their ultimate payment secure. 

§ 4. How to find the Wealth underljdng Property 

While it is sometimes difficult to discover the wealth be- 
hind a given property right, the difficulties may easily be 
removed by following a few simple guides, of which the fol- 
lowing are examples : — 



PROPERTY 27 

{a) The first guide is this : Always look for the benefit 
which the given property confers; and when your eye is 
fixed on those benefits, look around for the means hy which 
those benefits are produced. Benefits do not come of them- 
selves ; they always require actual, tangible, concrete, physi- 
cal means, — either persons or things. The means may not 
be the same as the cause. For instance, a man living in 
northern latitudes owns a house that has a southern exposure 
and therefore a great deal of sunlight. The benefits from 
that location, therefore, consist partly in abundant sunshine. 
Now, the land is the means of securing that sunshine, 
although the sun is the cause. Wealth, though it may not 
always be the cause, is always the means of benefits. Take 
as another example of property, a street railway franchise. 
If a city sells a franchise permitting a company to build 
and operate a railway through its streets, — what has 
the city sold ? Is it a right that has no wealth behind it ? 
No ; for there are benefits to be gained by the possession of 
the franchise — the sale of transportation ; and there 
are physical means to those benefits — the streets. The 
city streets are therefore the wealth behind the franchise 
which the city gives or sells. It gives or sells a right to use 
the streets. 

(b) A second guide lies in the fact that one property 
right often overlaps another. For instance, a mill is owned 
in shares : a railway company owns some of those shares ; 
a bank owns some of the railway shares ; and John Smith 
owns some of the bank shares. It is evident that John Smith 
has a claim upon the mill, although only distantly, i.e. 
through several intermediate layers of property rights. 

Such secondary relations between wealth and property 
occur when property is held in trust. At common law, the 
trustee is the legal owner ; but the law of equity recognizes 
the fact that the beneficiary is the true owner. That is, he 
has a claim against the trustee ; it is only for his benefit that 
the trustee holds the right to the wealth. Through the rights 



28 ELEMENTS OF ECONOMIC SCIENCE 

of the trustee, therefore, the beneficiary has an indirect but 
secure right to the benefits of the wealth. 

(c) A third guide is based on the fact that the correspond- 
ence between property and wealth is a contemporaneous corre- 
spondence. That is to say, existing property rights are 
rights to the use of existing wealth, so that existing wealth 
always underhes existing property rights. Next year's 
fruit crop may be sold in advance. The buyer then has the 
right to next year's fruit, but this is really a right to, or in, the 
present fruit trees, expected to bear the fruit. Likewise 
the right to next year's wheat is a right to, or in, the present 
farm, farmer, and farm implements. The right to receive a 
chair or table yet unmade is the right to, or in, the present 
person, tools, and other wealth of the carpenter, by which 
that chair or table is to be secured. It would seem at first 
that '' credit " forms an exception, for the right of a creditor 
is a present right to a future payment. But it is impossible 
to have a right to any future benefit which is not also a right 
to some present wealth as a means of securing that future 
benefit. To own a note falling due next year is a part right 
in the person and other " assets " of the promissor, and ceases 
to have value as soon as he ceases to be " good for it." It 
is true that the courts do not restrict a debtor in the disposi- 
tion of his possessions prior to the maturity of a note. 
He may elect to squander his resources. Such destruction of 
the present means of providing for future payment carries 
with it the impairment or destruction of the value of the note. 
No future benefits whatever can be owned in the present 
except as claims on certain requisites of their production that 
are already in existence. We cannot own next year's goods 
suspended in mid-air, as it were, any more than we can fly 
a kite without a cord. There must always be some present 
means of controlling the future. 

And not only is every right to a future benefit a claim on 
present wealth, but conversely, as already set forth in our 
definition of wealth, every claim on present wealth is a right 



PROPERTY 29 

to a future benefit. Owning rights to " futures " is therefore 
not an exceptional but rather the typical case. As we have 
seen, all wealth is the existing means toward future benefits, 
and all property consists of present rights to some of those 
future benefits. It is only through future benefits that 
wealth and property are bound together at all. The se- 
quence of ideas is : present wealth, future benefits, present 
rights to future benefits and therefore to the present wealth 
which is to yield future benefits. Property is thus always 
a present right to the chance of future benefits from present 
wealth. 

{d) Our fourth guide for finding the wealth underlying 
property is as follows : In cases of the partial ownership of 
wealth, we should remember that the aggregate of all partial 
rights constitutes the total ownership. Each partial right is a 
right to a part of the total future benefits. These benefits 
may be cut up among separate owners in different ways. 
But the total ownership of the wealth is always the aggregate 
of the rights to the entire stream of future benefits. The 
character and size, of this stream of benefits may of course 
differ according to the different methods by which ownership 
is parceled out. But this fact does not invalidate the prin- 
ciple that the total ownership is the combination of all the 
partial rights. 

The future benefits flowing from wealth may be compared 
to a pennant attached to a flagstaff, — a long streamer 
stretching out into the future. Some of the possible ways 
in which the present ownership of these pennants may be 
subdivided is indicated in Figure i, which contains three 
diagrams. The first represents the stream of benefits from 
a dwelling house. These begin at the present and stretch 
out indefinitely into the future. If two brothers own the 
house in partnership, each has a right to half the shelter of 
the house, i.e. to half of its benefits ; the benefits are there- 
fore divided, so to speak, longitudinally into two parts. 

But if the house is rented, the division of benefits between 



30 



ELEMENTS OF ECONOMIC SCIENCE 



B's SHARE OF FUTURE BENEFITS. 



A'S SHARE OF FUTURE BENEFITS. 



Temants 

SHARE 



Landlord'5 

SHARE 



the tenant and the landlord is transverse, as shown in the 
middle diagram. The tenant has all the benefits of the 
house for a certain time, after which the landlord has all 
the future benefits. 

The third diagram shows another way in which the benefits 
may be divided. This is by carving out a particular part of 

these benefits in the 
future. It may then 
be said that the bene- 
fits are cut up both 
longitudinally and 
transversely. For in- 
stance, a patron of the 
Metropolitan Opera 
House pays for the 
use of a " box " for 
next winter and all 
the benefits which go 
with it. He owns 
certain future benefits 
from that Opera 
House. He does not 
own the whole Opera 
House, yet he partly 
owns it, because he 
owns part of the uses 
or benefits to be derived from it. The part he owns (the 
benefits of the box for next winter) may be represented 
by a small rectangle cut out of the entire stream of benefits 
from the theater. When a promise is made and a man sells 
this promise for present money, he has cut out some part of 
the benefits which in the future will emanate from his person 
and his other wealth. 

It is plain, then, that the succession of benefits emanating 
from any article of wealth may be cut up longitudinally, or 
transversely, or by cutting out a certain part. 



USE or 
BOX 



Present 

IfNSTAMT 



Fig. I. 



PROPERTY 31 

In common speech, the minor rights to wealth are not or- 
dinarily dignified as rights of ownership. Thus, a tenant's 
right in the dweUing he occupies is sharply distinguished from 
the right of the owner. Yet, strictly speaking, every right 
to use wealth, however insignificant, is a part ownership. 
When an owner of land wishes to sell an unencumbered title, 
he finds it necessary to extinguish all outstanding leases, or 
claims for future benefits, often at considerable cost. It is 
the total ownership which he professes to sell and the total 
ownership always includes the ownership which the tenant 
enjoys. 

Applying the above rules there can be no difficulty in 
discovering for each property right some underlying wealth 
in conformity with the general principle that wealth and 
property are coextensive. 

§ 5. Practical Problems of Property 

Since wealth and property are inseparable, economics 
might be called the science of property as well as the science 
of wealth. When we treat of the welfare of a community, 
we think rather of wealth than of property. When we 
treat of the welfare of an individual, we think rather of 
property than of wealth. The fact that wealth and property 
are coextensive should be emphasized because it will save 
us from confusions which are all too common, and it will 
save us also from many practical blunders growing out of 
these confusions. If our State legislatures understood this 
principle, there would be less of the iniquitous double taxation 
that is the bane of present systems of State and local taxa- 
tion. Such unjust taxation is illustrated by the case of the 
Massachusetts factory owner who decided to transfer his 
property to a stock company of which he himself should hold 
all the stock. Previously he paid taxes only on the factory 
itself ; but when the " company " was formed, the tax collec- 
tor came along and informed him that henceforth not only 



32 ELEMENTS OF ECONOMIC SCIENCE 

must the " company" pay taxes on the factory, but that he 
personally must pay taxes on the stock also, since stock is 
taxable " personal property." -Thus the owner was taxed 
both on the stock which represented the factory and on the 
factory itself. Such instances of double taxation are quite 
common in the United States though they are not all so 
self-evident as this. 

Many of the most important problems of economic policy 
are problems of the form of ownership of wealth. The 
great slavery question turned upon the problem whether one 
man should be owned by another, or whether he should own 
himself. It was partly a question whether one man could 
steal another man away from Africa, and partly a question 
whether any man could sell himself. Those questions have 
been settled in the negative, and it is now regarded as bad 
public policy for one man to own another in fee simple. Yet 
we do own partial rights in others. In fact it is very difficult 
to find a man so free that some one has not a claim upon him. 
These partial rights are, of course, very different in their 
practical effects from perpetual ownership. 

Another property problem, and one somewhat similar, 
is that of perpetual franchises. Is it good public policy to 
grant to a street railway company in perpetuity the rights 
to use a city's streets ? Or ought we to fix a time limit, say 
fifty years, after which the rights revert to the city? A 
kindred question has been raised by Henry George and 
others as to private property in land. Is it wise public 
poHcy that the present form of land ownership in fee simple 
should continue ? Ought a man to have the right to a piece 
of land forever, — perhaps abusing that right, obstructing 
others, and neglecting the opportunities which it affords? 
Should the government step in and lease the land for limited 
periods? This question is now being discussed with ref- 
erence to our mineral lands and particularly our coal lands 
in Alaska. Questions of land ownership have in all ages 
vexed men's minds and been the source of social unrest. 



PROPERTY 33 

Rome had her agrarian troubles ; not unUke those of modern 
England and Ireland. 

The right to bequeath property is also a prime source of 
trouble. The right to dispose of property by will has not 
always been recognized. It was developed by the Romans, 
from whose system of law we borrowed it. Even now it is a 
limited right, and its exercise differs with law and custom. 
These differences are responsible, for instance, for peasant 
proprietorship in France and primogeniture in England. 
The right has, indeed, been limited so as to prevent the per- 
petual tying up of an estate by a testator. Its further 
limitation will probably be one of the problems of the 
future. 

An even broader question of the same sort is the question 
of socialism. Shall we continue what is called private 
property, except in the things that we wear and eat, and 
possibly the houses in which we hve? That is, shall we 
allow our railways and our factories to be owned by private 
individuals? Or shall they be owned by the community 
at large so that we may all have shares in them, as we already 
have in the post ofhce and the government printing oihce ? 
These are some of the greatest problems in economics ; 
and they are problems concerning the ownership of wealth. 

§ 6. Table of Typical Property Rights 

The foUow^ing table indicates the most important types of 
property, and shows in each case the wealth on which the 
property right is based and the benefits accruing from 
that wealth. The most important forms are : fee] simple, 
stocks, bonds, notes, leases, partnership rights, and con- 
tracts. 



34 



ELEMENTS OF ECONOMIC SCIENCE 



TYPICAL CASES ILLUSTRATING THE EXISTENCE OF 
WEALTH BEHIND PROPERTY RIGHTS 



Name of Case 


Wealth on which 
THE Property 
Right is Based 


Benefits of 
THAT Wealth 


Description of 
Property Right 


Certificate 
OF Ownership 

IF Any 


Fee Simple 


Farm 


Yielding crops 


Right to all use 
of farm for- 
ever 


Deed 


Partnership 


Dry Goods 


Yielding profits 


One partner's 


Articles of 






from sale 


" undivided " 
one-third in- 
terest 


agreement 


Joint Stock 


Railway 


Yielding profits 


The shares of 
stock 


Stock certifi- 
cate 


Street Fran- 


Street 


Use of same for 


Right to run 


Charter 


chise 




passage, etc. 


cars through 
it 
Right to run 


















wires through 
it 
Right of tenant 




Lease or Hire 


Dwelling 


Use of same for 


Lease 






for shelter, etc. 


tiU fixed date 
Right of land- 
lord thereafter 




Railway Ticket 


Railway 


Transportation 


Right to speci- 
fied trip 


Ticket 


Railway Bond 


Railway 


Payment of " in- 


Right to same 


Bond certifi- 






terest " and 


and contin- 


cate 






" principal " 


gent right to 
foreclose 




Personal Note 


All the posses- 
sions of the 
signer 


Payments 


Right to same 
and in de- 
fault thereof , 
right to collat- 
eral security 


Note 


Monopoly 


General wealth 


Refraining from 


Right to compel 


Charter 


Franchise 


of community 
(persons in- 
cluded) 


doing similar 
business 


same 




Government 


Streets, public 


Uses of same 


Right to walk 


Official re- 


Property 


parks and 




over and 


corded plats. 




buildings 




otherwise use 
same 


old grants, 
individual 
dedications 
deeds 



CHAPTER III 

CAPITAL 

§ I. Capital and Income 

In the foregoing chapters we have set forth several funda- 
mental concepts of economic science, — wealth, property, 
benefits, price, and value. We have seen that wealth con- 
sists of material appropriated objects, and that property 
consists of rights in these objects ; that wealth in its broadest 
sense includes human beings, and property in its broadest 
sense includes all rights whatsoever; that benefits are the 
desirable occurrences which happen through wealth; that 
prices are the ratios of exchange between quantities of wealth, 
property, or benefits ; and that value is price multiplied by 
quantity. These concepts are the chief tools needed in eco- 
nomic study. 

Little has yet been said about the relation of these various 
magnitudes to time — that great '' independent variable " 
of human experience. When we speak of a certain quantity 
of wealth, we may refer either (i) to a quantity existing at a 
particular instant of time, or (2) to a quantity produced, con- 
sumed, exchanged, or transported during a particular period 
of time. The first is a stock of wealth ; the second is d^flow of 
wealth. A stock is fully specified by one magnitude only, 
namely, its amount. But a flow requires two, — the amount 
of what flows and the duration of its flow. From these two 
we derive a third, namely, the rate of flow, or the quotient of 
the number representing the amount divided by the number 
representing the duration. The rate of flow is often more 
important than the amount of flow. We care less to know 

35 



36 ELEMENTS OE ECONOMIC SCIENCE 

the aggregate wages of a workman during his lifetime than 
his rate of wages during various periods of his Hfe. The 
most important purpose of this distinction between a stock 
and a flow is to differentiate between capital and income. 
Capital is a stock, and income a flow. This, however, is not 
the only difference between capital and income. There is 
another, equally important ; namely, that capital is wealth, 
and income is the benefit of wealth. We have, therefore, the 
following definitions : A stock of wealth existing at a given 
instant of time is called capital} A flow of benefits through 
a period of time is called income. A dwelhng house now exist- 
ing is capital ; the shelter or the rent it affords is its income. 
The railways of the country are capital ; their benefits (in 
the form of transportation) are the income they yield. 

§ 2. Senses of the Term '' Capital " 

We have defined capital as a quantity of wealth existing at 
a given point of time. An instantaneous photograph of 
wealth would reveal, not only a stock of durable wealth, 
but also a stock of wealth of rapid consumption. It would 
disclose, not the annual procession of such goods, but the 
members of that procession that had not yet been transmuted 
in form or had not yet passed off the stage of existence, how- 
ever swiftly they might be moving across it. It would show 
trainloads of meat, eggs, and milk in transit, cargoes of 
fish, spices, and sugar, as well as the contents of private 
pantries, ice chests, and wine cellars. Even the supplies on 
the table of a man bolting his dinner would find a place. So 
the clothes in one's wardrobe or on one's back, the tobacco 
in a smoker's pouch or pipe, the oil in the can or lamp, would 
all be elements in this flashHght picture. 

^^ Many authors restrict the name capital to a particular kind or species of 
wealth, or to wealth used for a particular purpose, such as the production 
of new wealth ; in short, to some specific part of wealth instead of any or all 
of it. Such a limitation, however, is not only difficult to make, but cripples 
the^usefulness of the concept in economic analysis. 



CAPITAL 37 

Not only is a stock of wealth called capital, but a stock of 
property is also called capital. The two may be distin- 
guished as capital-wealth and capital-property. Again, the 
value of either is called capital ; and this third kind of capital 
may be distinguished as capital-value. 

A capital account is a statement of the amount and value 
of the property of a specific owner at any instant of time. 
It consists of two columns, — the assets and the liabilities, — 
the positive and negative items of capital. The Habilities of 
an owner are his debts and obligations to others; that is, 
they are the property rights of others for which this owner 
is responsible. The assets or resources of the owner are all 
his property rights, irrespective of his habilities. The assets 
include both the property which makes good the liabilities, 
and the property, if any, in excess of the liabihties. They 
also include, if exhaustively considered, the person of the 
owner himself, if that owner is a real person and not an 
artificial person, such as a corporation. 

The owner may be either such a physical human being, or 
it may be an abstract entity in which a collection of human 
beings is interested, such as an association, a joint stock 
company, a corporation, or a government. With respect 
to a debt or liabihty, the person who owes it is the debtor, 
and the person owed is the creditor. The difference in 
value between the total assets and the total liabihties of 
either individual is the net capital, or capital-balance indi- 
cated in the account of such individual. 

The items in a capital account are constantly changing, 
and their values also ; so that when, after one statement of 
assets and liabihties is drawn up, and another is constructed, 
say a year later, the balancing item, or net capital, may have 
changed considerably. However, bookkeepers are accus- 
tomed to keep the ^' capital " item intact from the beginning 
of their account, and to characterize any increase of it as 
'* surplus " or '^ undivided profits." There are several 
reasons for this bookkeeping poHcy. In the first place, 



38 ELEMENTS OF ECONOMIC SCIENCE 

the less often the bookkeeper's entries are altered, the sim- 
pler the bookkeeping. Again, by stating separately the 
original capital and its later increase, the books show at a 
glance what the history of the company has been as to the 
accumulations of capital. Finally, in the case of joint stock 
companies, the capital is represented by stock certificates, the 
engraved " face value " of which cannot conveniently be 
altered to keep pace with changes in real value. Conse- 
quently, it is customary for bookkeepers to maintain the 
book value if the '' capital " is equal to the face value of the 
certificates. But this bookkeeping policy does not alter 
the fact that at a given instant the owner's capital consists 
of the entire excess of his assets over his liabilities, including 
the accumulated surplus and undivided profits. 

The following two balance sheets show the accumulation 
of that part of capital which bookkeepers separate from the 
capital account and call ^' surplus." 

JANUARY I, 1910 

Assets Liabilities 

Plant $200,000 Debts $100,000 

Capital (owed to the 

stockholders) . . 100,000 

$200,000 $200,000 



JANUARY I, 1911 

Plant, etc. .... $246,324 Debts $100,000 

Capital . . . . . 100,000 

Surplus 46,324 

$246,324 $246,324 

But not only is the book item, " capital," maintained in- 
tact as long as possible, but often the surplus also is put 
in round numbers and kept at the same figure for several 
successive reports. That is, the smaller fluctuations are 



CAPITAL 39 

registered in a third item, called " undivided profits." The 
distinction between surplus and undivided profits is thus 
merely one of degree. The three items — capital, surplus, 
and undivided profits — together make up the total present 
net capital. Of this, " capital " represents the original 
capital, " surplus " the earlier and larger accumulations, 
and " undivided profits " the later and minor accumulations. 
The undivided profits are more Hkely soon to disappear in 
dividends, that is, to become divided profits, although this 
may also happen to the surplus, or even in certain cases to the 
capital itself. 

We see, then, that the capital of a company, firm, or person, 
is to be understood in two senses : first, as the item entered 
by the bookkeeper under that head, — the original capital ; 
and secondly, this sum plus surplus and undivided profits, — 
the true net capital at the instant under consideration. 

Inasmuch as the stock certificates were issued at the for- 
mation of the company, and cannot be perpetually changed, 
they ordinarily correspond to the original capital instead of 
the present capital. RecapitaHzation may be effected, how- 
ever, by recalling the stock certificates and issuing new ones. 
In this way the nominal or book value may be either de- 
creased or increased. It is sometimes scaled down because of 
shrinking assets, and sometimes increased because of new 
subscriptions or expanding assets. If, for instance, the 
original capital was |ioo,ooo, and the present capital (in- 
cluding the surplus and undivided profits) is $200,000, 
it would be possible, in order that the total certificates out- 
standing might become $200,000, and the surplus and un- 
divided profits be enrolled as capital, to issue stock certifi- 
cates free to each stockholder. Such an issue of stock is 
called a stock dividend. Ordinarily, however, the stock 
certificates remain as originally, and merely increase in 
value. Thus, if the present capital is $200,000, whereas 
the original capital and the outstanding certificates amount 
to only $100,000, the " market value " of the shares will be 



40 ELEMENTS OF ECONOMIC SCIENCE 

double the face value; for the stockholders own a 
total of $200,000, represented by certificates whose " face 
value " is $100,000. 

§ 3. Book and Market Values 

If, however, we attempt to verify such a relation by refer- 
ence to the company's books, we shall find some discrepan- 
cies in the results. For instance, a national bank of New 
York reported a total capital, surplus, and undivided 
profits of $1,295,952.59, of which the original capital was 
only $300,000. We should expect, therefore, that the 
stock certificates, amounting to $300,000, would be worth 
$1,295,952.59, or, in other words, that each $100 of stock 
certificates would be worth $432. The actual selling price, 
however, was about $700. The discrepancy between $432 
and $700 is due to the fact that there are two estimates of 
the capitalized value of earning power, — one that of the 
bookkeeper, which is seldom revised and usually conserva- 
tive, and the other that of the market, which is revised almost 
daily. The stockholders of this bank were credited by the 
bookkeeper with owning $1,295,952.59, whereas, in reality, 
the total value of their property was more nearly $2,100,000. 
The bookkeeper systematically undervalued the assets 
of the bank, and even omitted some valuable assets alto- 
gether, such as " good will." The object of a conservative 
business man in keeping his books is not to obtain mathe- 
matical accuracy, but to make so conservative a valuation as 
to be well within the market. 

Of the two valuations of the capital of a company, 
the bookkeeper's and the market's, the latter is apt to be the 
truer of the two, although it must be remembered that each 
of them is merely an appraisement. The ordinary book- 
keeper's figures, which have so imposing an appearance of 
accuracy, are in reality, and often of necessity, very wide of 
the mark. 



CAPITAL 41 

§ 4. Case of Decreasing Capital-balance 

We have seen that the effect upon the balance sheet of an 
increase in the value of the assets is to swell the surplus or 
the undivided profits. Conversely, a shrinkage of value 
tends to diminish those items. For instance, if the plant of a 
company having a capital of $100,000 and a surplus of 
$50,000 depreciates to the extent of $40,000, the effect 
on the books will be as follows : — 

ORIGINAL BALANCE SHEET 

Assets Liabilities 



Plant .... $200,000.00 


Debts .... $150,000.00 


Miscellaneous . . 101,256.42 


Capital .... 100,000.00 




Surplus .... 50,000.00 




Undivided profits 1,256.42 


$301,256.42 


$301,256.42 


PRESENT BALANCE SHEET 


Assets 


Liabilities 


Plant $160,000.00 


Debts .... $150,000.00 


MisceUaneous . . 101,256.42 


Capital .... 100,000.00 




Surplus .... 10,000.00 




Undivided profits 1,256.42 


$261,256.42 


$261,256.42 



Here the shrinkage in the value of the plant, as recorded on 
the assets side, '^ comes out of the surplus," as recorded on 
the liabihties side. 

In case the surplus and undivided profits have both been 
wiped out, the capital itself becomes impaired. In this case 
the bookkeeper may indicate the result by scaling down the 
capitalization. This sometimes occurs in banks and trust 
companies, but not often in ordinary business. It is often 
avoided by making up the deficiencies through assessment 
of stockholders or postponement of dividends. Such meas- 



42 ELEMENTS OF ECONOMIC SCIENCE 

ures are required by law in many cases, as in that of insurance 
companies. Dishonest concerns, however, often conceal 
their true condition by the reverse process of exaggerat- 
ing the value of the assets. Sometimes this is done system-, 
atically, as in the case of stock- jobbing concerns. The 
sums intrusted to unscrupulous promoters by confiding 
stockholders are often invested in unwise or fraudulent ways. 
For instance, take an Oil Well Company in California, 
of the illegitimate type called " stock-producing wells.'' 
Suppose it borrows $50,000 and collects $50,000 more from 
the sale of stock (at par), and with this $100,000 purchases 
land of friends at a fancy price, coUusively providing that 
the proceeds be returned in large part to the promoter. In 
such a case the books of the bubble concern will show the 
following figures : — 

Assets Liabilities 

Land $100,000 Debts $50,000 

Capital 50,000 

$100,000 $100,000 

But if the land is worth, say only $60,000, these accounts 
should read : — 

Assets Liabilities 

Land $60,000 Debts . ' $50,000 

Capital 10,000 

$60,000 $60,000 

In other words, the investor has only $10,000 worth of 
property, instead of the $50,000 which he put in, or 20 cents 
for every dollar invested. The rest has been diverted into 
the pockets of the promoter and of those in collusion with 
the promoter. 

This is an example of what, in commercial slang, is called 
" stock watering," which may be defined as the issue of 
stock without a corresponding increase in actual capital 



CAPITAL 43 

value. It is sometimes said that there is no wrong in stock 
watering, so long as it is fully known. This is much like 
saying that to lie is not wrong provided everybody knows 
you are lying. Stock watering usually represents an inten- 
tion to deceive, and through this deceit injury may be done 
both to buyers of stock and buyers of bonds. The buyers 
of stock are injured if they buy without knowledge of the 
proposed stock watering, and the bond buyer is injured if 
the watering of the stock, having given him a false idea of 
the actual capital, induces him to lend more money than the 
capital can satisfactorily secure. 

§ 5. Insolvency 

The original capital of a concern may be either increased 
or decreased. In the course of its fluctuations it may some- 
times shrink to zero. If it shrinks below zero, we have 
" insolvency," — the condition in which assets fall short of 
liabilities. The capital-balance is intended to prevent this 
very calamity ; it is for the express purpose of guaranteeing 
the value of the other liabiHties, — those to bondholders and 
other creditors. 

These other liabilities, for the most part, are fixed blocks 
of property, carved, as it were, out of the assets, and which 
the merchant or company has agreed to keep intact at all 
hazards. The fortunes of business will naturally cause the 
whole volume of assets to vary in value, but all this " slack" 
ought properly to be taken up or given out by the capital, 
surplus, and undivided profits. A man's capital thus acts as 
a buffer to keep the liabilities from overtaking the assets. 
It is the '' margin " he puts up as a guarantee to others who 
intrust their ca^pital to him. 

The amount of capital-balance necessary to make a busi- 
ness reasonably safe will differ with circumstances. A 
capital-balance equal to 5 per cent of the liabilities may, 
in one kind of business, such as the business of a mortgage 



44 ELEMENTS OF ECONOMIC SCIENCE 

company, be perfectly adequate, whereas 50 per cent may be 
required in another kind. Much depends on how likely 
the assets are to shrink and to what extent ; and much, like- 
wise, depends on the character of the habilities. 

The risk of insolvency is the chance that the assets may 
shrink below the liabilities. This risk is the greater, the 
more shrinkable the assets, and the less the margin of capital 
value between assets and liabihties. 

Insolvency must be distinguished from insufficiency of 
cash. The assets may comfortably exceed the liabilities, 
and yet the cash assets at a particular moment may be less 
than the cash liabilities due at that moment. This condi- 
tion is not true insolvency, but only insufficiency of cash. 
In such a case, a little forbearance on the part of creditors 
may be all that is necessary to prevent financial shipwreck. 

A wise merchant, however, will not only avoid insolvency, 
but also insuihciency of cash. He will not only keep his 
assets in excess of his liabilities by a safe margin, but he will 
also see that his assets are invested in such a manner that 
he shall be able to cancel each claim at the time and in the 
manner agreed upon. 

From this point of view there are three chief forms of assets, 
— already touched upon in Chapter I, — cash assets, quick 
assets, and slow assets. A cash asset is property in actual 
money, or what is acceptable in place of money. A quick 
asset is one which may be exchanged for cash in a relatively 
short time, as, for instance, call loans, short- time loans, and 
other marketable securities. A slow asset is one which may 
require a relatively long time to be exchanged for cash. Such 
are real estate, office fixtures, and manufacturers' equipment. 

If all property were as acceptable as money, there would 
be no need of classifying assets into these three groups. 
But since the creditor will not accept railway stock or bonds, 
when he has contracted for payment in money, the debtor 
must maneuver so as to keep on hand a sufficient quantity 
of quick assets and of cash assets to enable him to meet his 



CAPITAL 45 

obligations when they are due. A large part of the skill of a 
business man consists in marshaling his assets so that he 
always has enough cash, and quick assets to provide for im- 
pending debts, while maintaining at the same time enough 
slow assets to insure a satisfactory income from his 
business. 

Originally, before business was separated from private Hfe, 
all of a debtor's assets, even including his own person, were 
regarded as pledged to the payment of a debt. An insolvent 
debtor could be imprisoned. To-day, however, laws exist 
in most countries by which a bankrupt may be discharged, 
free from further liabihty. 

Since the liabiKties of one man are also the assets of an- 
other, when one man fails and is able to pay only fifty cents 
on the dollar, the unlucky man who is his creditor, — who 
has his notes as assets, suffers a shrinkage in his own assets 
which may in turn mean embarrassment or even bankruptcy 
to him. It is usually true in a panic that the failures start 
with the collapse of some big firm, involving a shrinkage in 
the assets of others. This indicates why assets ought usually 
to be undervalued. A man who is in debt has no right to 
exaggerate his means of payment. A conservative and 
honest business man will therefore always undervalue rather 
than overvalue his assets, in order to be fair to his creditors. 

§ 6. Two Methods of combining Capital Accounts 

We have seen how the capital account of each person in a 
community is formed. We are, however, more interested 
in the bookkeeping of society at large than in the book- 
keeping of the individuals composing it. Our next task, 
therefore, is to express the total capital of any community. 
This is the sum of the capital of its members, that is, all the 
assets less all the liabilities. There are two chief ways of 
combining these plus and minus items in order to obtain the 
total for society at large. 



46 ELEMENTS OF ECONOMIC SCIENCE 

The simplest is to obtain first the net capital balance of 
each person by subtracting the value of his HabiKties from 
that of his assets, and then to add these net capitals together, 
as the capital of society. This is the method of balances. 
We balance the books of each individual. But we may add 
and subtract the items of assets and liabilities in many other 
ways. One way which takes account of the network of debts 
and credits between individuals is to couple each Hability 
with its equal and opposite asset, existing in another indivi- 
dual's account and cancel these two against each other. This 
is called the method of couples. We couple items in different 
accounts. This method of couples is based on the fact that 
every liability item in a balance sheet imphes the existence of 
an equal asset in some other balance sheet. This is true 
because every debit imphes a credit. It follows that every 
negative term in one balance sheet may be canceled against 
a corresponding positive term in some other. Each of these 
two methods — of balances and of couples — is important 
in its own way. 

Let us illustrate each by the balance sheets of three 
persons, say X, Y, and Z : 







PERSON X 






Assets 




Liabilities 


Z's note 
Residence 
Railroad sh; 


ares . . 


$30,000 A 
70,000 
20,000 


Mortgage held by Y 
(Capital balance 


$50,000 h 
70,000) 




$120,000 


$120,000 



Person Y 

Assets Liabilities 

X's mortgage . . . $50,000 B Debt to Z . . . . $40,000 c 

Personal effects . . 20,000 (Capital balance . . 40,000) 
Railroad shares . . 10,000 

$80,000 $80,000 





CAPITAL 47 




Person Z 


Assets 


LlABILlTlKS 


Y'sdebt . . . 
Farm . . . . 
Railroad bonds . 


$40,000 C Debt to X ... $30,000 a 
50,000 (Capital balance . . 80,000) 
20,000 



$110,000 $110,000 

Each couple of corresponding items — i.e. each item which 
appears twice, once as a liability of one man and again as an 
asset of another — is indicated in both places by the same 
letter. Thus, '^ A " in '' X's " assets is matched by the 
equal and opposite item " a " in Z's liabihties. The method 
of couples thus consists in omitting from society's balance 
sheet these pairs of items, and entering only those which 
remain uncanceled. These, in the present case, are all 
assets. 

The results of summing up the capital accounts by the 
two methods are shown in the following tables : — 

Method of Balances Method of Couples 

X's capital .... $70,000 Residence $70,000 

Y's capital .... 40,000 Personal effects . . . 20,000 

Z's capital .... 80,000 Farm 50,000 

Railroad shares . . . 30,000 

Railroad bonds . . . 20,000 



$igo,ooo $190,000 

The totals are the same by both methods, but the method 
of balances shows the share of this total capital which is 
owned by each individual, while the method of couples shows 
portions ascribable to each different capital-good. 

§ 7. Real and Fictitious Persons 

It is well to note here the distinction between the account- 
ing of real persons and of fictitious persons (such as corpora- 
tions). For a real person, the assets may be, and usually 



48 ELEMENTS OE ECONOMIC SCIENCE 

are, in excess of the liabilities, and the difference is the 
capital-balance of that person. This capital is not to be 
regarded as a liability, but as a balance or difference be- 
tween the liabilities and the assets. For a fictitious person, 
on the other hand ( a corporation or partnership), the Ha- 
bilities are always exactly equal to the assets ; for the balanc- 
ing item called capital is as truly an obligation (from the 
fictitious person to the real stockholders) as any of the other 
liabilities. A fictitious person, in fact, is a mere bookkeep- 
ing dummy, holding certain assets and owing all of them out 
again to real persons, including the stockholders. Book- 
keepers, it is true, apply the same methods in both cases, 
but they do so by regarding the account even of a real person 
as relating to a fictitious entity for bookkeeping purposes. 
For bookkeeping purposes, one's business self and one's 
real self are separated. Thus, if X's business shows a balance 
in X's favor of $10,000, he enters this as a liability item in 
his business accounts and considers his " business " as owing 
him this sum. There is no objection to such a procedure. 
But we must remember that when we say that X's " busi- 
ness " owes X $10,000, we imply that the real X in his own 
accounts holds a claim of that amount against his "business." 
In other words, we are compelled, in order to be consistent, 
to open a separate account for X as an individual, and carry 
forward the $10,000 balance from the debit side of his busi- 
ness accounts to the credit side of his personal accounts, 
thus : — 

X's Business 

Assets Liabilities 

Miscellaneous . . . $50,000 Due to others . . . $40,000 

Due to X . . . . . 10,000 

$50,000 $50,000 

X's Self 

Assets 

Due from "X's busi- 
ness " $10,000 



CAPITAL 49 

But in the second account there is no counterbalancing lia- 
bility. For real persons, then, in the last analysis, — that is, 
as represented by " X's self," — the value of assets and that 
of liabiKties are not equal. If they were, the addition of 
their balance sheets would yield zero for society. 

§ 8. Ultimate Result of Method of Couples 

With this preliminary explanation, let us now introduce 
into our addition the capital accounts of the railroad whose 
stocks and bonds are included among the assets of persons 
X, Y, and Z. For simplicity, we shall suppose that these 
three persons are the only persons interested in the road. 
The balance sheet of the railroad company will accordingly 
appear as follows : — 

Railroad Company 

Assets Liabilities 

Railway $50,000 Bonds (held by Z) . . $20,000 

Capital stock 
(held by X) $20,000 
(held by Y) $10,000 30,000 

$50,000 $50,000 

Now if we combine this balance sheet with the preceding, 
we shall see that its inclusion does not affect the results 
which were obtained by the method of balances before the 
railroad was introduced into the discussion. The totals 
will stand as follows : — 

X's capital balance $70,000 

Y's capital balance 40,000 

Z's capital balance 80,000 

Railroad Co.'s capital balance .... 00,000 

$190,000 

When we apply the method of couples, however, we find 
that the inclusion of the railway company's capital account 

E 



50 ELEMENTS OF ECONOMIC SCIENCE 

will affect the items in the final sum. The stocks and bonds, 
as assets of X, Y, and Z, will now pair off with the corre- 
sponding Kabilities of the railroad company, and their place 
will be taken by the concrete railroad itself, as follows : — 

Method op Couples 

Residence $70,000 

Personal effects 20,000 

Farm 50,000 

Railway 50,000 

$190,000 

The appearance of the capital inventory is thus changed. 
Formerly, the items of property rights in it included such 
part-rights as stocks and bonds ; now they consist only of 
complete property rights. But the complete right to any 
article of wealth is best expressed in terms of the article of 
wealth itself. Consequently, instead of the long phrase, 
the " right to a residence," we merely use " residence." 
The property no longer veils the wealth beneath it, and the 
inventory, which before was called an inventory of property- 
capital, is now also an inventory of wealth-capital. 

Such a result is sure to follow when we combine capital 
accounts, provided we combine enough of them to supply, 
for every liability item, its counterpart asset, and for every 
asset which has one, its counterpart liabiKty. These assets 
which have no counterparts are what we have called complete 
rights to wealth, or '' fees simple " ; those assets which do 
have counterparts are the partial rights to wealth. The 
reason is that every article of concrete wealth is to be re- 
garded as owned in " fee simple " by some one, even if we 
have to set up a fictitious person or dummy for that very 
purpose. Hence, every part-right to such an article 
of concrete wealth will necessarily appear as a Habil- 
ity on the opposite side of the fictitious person's account. 
Thus, if two brothers own a farm in equal shares, the shares 
will appear as assets in the brothers' individual accounts ; but 



CAPITAL 51 

since the farm as a whole is regarded as owned by the partner- 
ship person called '^ Smith Brothers," the balance sheet of 
this fictitious person will show as assets the farm itself, 
and as liabihties the " undivided half interest " of each 
brother. 

To follow out totals of capital thus requires the inclusion 
of many fictitious persons, for it is often only the fictitious 
persons who hold the complete rights. Locomotives and 
railway stations, for instance, are owned by corporations, 
not individuals. In fact, these fictitious persons — partner- 
ships, corporations, trusts, municipahties, associations, and 
the like — are formed for the express purpose of holding 
large aggregations of concrete wealth and parceling out its 
ownership among a number of real persons. 

If, then, we suppose balance sheets so constructed as to 
include all the real and fictitious persons in the world, with 
entries in them for every asset and hability, — even public 
parks and streets, household furniture, persons themselves, 
and other possessions not ordinarily formally accounted for 
in practice, — it is evident that we shall obtain, by the 
method of balances, a complete account of the distribution of 
capital- value among real persons ; and, by the method of 
couples, a complete hst of the articles of actual wealth 
thus owned. In this hst there will be no stocks, bonds, 
mortgages, notes, or other part-rights, but only land, build- 
ings, and other land improvements, commodities, and real 
persons. In other words, we arrive again at the proposition 
of Chapter II, that wealth underHes and corresponds to 
property. 

§ 9. Confusions to be Avoided 

Among part-right in real wealth is " credit." There has 
been much discussion as to the nature of credit ; whether, in 
particular, credit is to be regarded as capital. It has been 
claimed that from the merchant's point of view credit is 
capital because it enables a business man to enlarge his busi- 



52 ELEMENTS OF ECONOMIC SCIENCE 

ness. But this view entails double counting. We have seen 
from our study of capital accounts how to avoid such double 
counting. That part of a man's so-called capital which is 
borrowed cannot enter his books as his capital at all, being 
but a manifestation of the fact that the total capital of the 
community is owned in part by others. Indeed, the phenom- 
enon of credit means nothing more or less than a specific 
form of divided ownership of wealth. Credit merely en- 
ables one man temporarily to control more wealth or prop- 
erty than he owns — that is, some part of the wealth or 
property of others. 

It is therefore a cardinal error to regard credit as in- 
creasing of the capital of the debtor. Indirectly, credit 
may result in an increase of society's capital, by stimulating 
trade and production, as well as by getting the management of 
capital into the right hands and its ownership into the most 
effective form. In these ways the earth is made to yield up 
more wealth or greater benefits from the same wealth, — in 
either case entailing an increase of " capital," — i.e. '' capital- 
wealth " or '' capital- value"; but the amount of any such 
increase of capital thus indirectly produced bears no neces- 
sary relation to the amount of the credit which facilitated its 
production. If capital is increased, the credit does not 
constitute the increase, but merely represents a part ownership 
in the final total, after all the increments have been included. 

A great deal of confusion in legislation and discussion could 
be avoided if the two methods of combining capital accounts 
were distinguished and their interrelations recognized. In 
taxation, the two methods are often confused. A chief 
problem of efficient taxation is how to tax all property once, 
and none of it more than once. There are two solutions : 
One is to tax the amount owned by each real person in a list 
which expresses the method of balances ; this method seeks 
out the real owners or part-owners of wealth. The other is to 
tax the actual concrete wealth in a list which expresses the 
method of couples ; this method seeks out the real wealth 



CAPITAL 53 

owned. At present the twcare much confused. Legislators 
too often fail to perceive that under the first, or owner- 
method, corporations should not be taxed, for they are not 
true owners ; and that under the second, or wealth-method, 
bonds, stocks, and other part-rights to wealth should not be 
taxed, for these are sufficiently included when the actual rail- 
ways and other items of physical wealth underlying such 
part-rights are taxed. It is not claimed, of course, that a 
complete system of taxation can be worked out merely 
by choosing one of the two methods just indicated. But the 
distinction between the two should be observed, for where 
one system is applied the other cannot also be applied with- 
out double taxation. 



CHAPTER IV 

INCOME 

§1. Concepts of Income and Outgo 

The income from any particular instrument has been de- 
fined as the flow of benefits from that instrument. These 
benefits may sometimes consist of money payments; but 
it is important to avoid the mistaken notion that they con- 
sist always of money payments. Income is the flow of 
whatever benefits accrue from any instrument, whether these 
benefits happen to be in the form of money or not. A self- 
supporting farmer, for instance, may not receive or expend 
a single dollar from one year's end to the^^other, yet he has 
an income. He gets a living — the most important kind 
of income — from the farm. A windmill pumps water ; 
the pumping is the benefit or income resulting from the 
windmill. A derrick hoists coal from a mine ; the hoisting 
is its income. Human beings do work ; their work is an 
item of society's income, as are all the operations of 
industry and all the transactions of commerce. When axes 
fell trees and sawmills turn them into lumber, these 
changes constitute the income flowing from the agencies 
which produce them. When a manufacturing plant con- 
verts raw materials into food or into fabrics or into imple- 
ments, these changes constitute the gross income produced 
by the plant. The warmth and shelter that a house pro- 
vides for its occupants go to make up the income furnished 
by the house. What we call agriculture, mining, commerce, 
and domestic operations are large and important classes of 
income, yielded by similar agencies. 

54 



INCOME 55 

Income, being a flow of benefits, implies a stock or fund 
of instruments which produces the flow. This stock of 
instruments is what we have aheady designated as " cap- 
ital." 

It has already been noted that income differs from cap- 
ital in two respects. In the first place, it is a flow relating 
to a stated period, whereas capital is a fund relating to a 
given instant. In the second place, it consists of (intangible) 
benefits, whereas capital consists of (tangible) instruments ; 
not farms, therefore, nor houses, nor food, nor railroads, nor 
artesian wells, nor goods of any sort can ever constitute 
income. Income consists rather in the yielding of crops 
by the farm ; the warming and sheltering of people by the 
houses ; the nourishing of people by the food ; the trans- 
porting of passengers and freight by the railroads ; the rais- 
ing of water by the wells ; and benefits of any sort by goods 
of any sort. 

Although income consists partly of other benefits than 
money receipts, all income, like all capital, may be trans- 
lated into terms of money. And to income as to capital 
may be applied the concepts of price and value. 

So much for gross income, the positive side of the income 
account. But just as in our capital account we found a 
negative side — comprising the liabilities, — so we shall find 
a negative side to income. The negative of income is called 
outgo, and the items which constitute outgo are called costs. 
A cost of an instrument has been already defined as the oppo- 
site of a benefit of an instrument. It is an undesirable event 
occasioned by the instrument. Labor, trouble, expense, and 
sacrifice of all sorts are entailed by wealth and are counted 
among its costs. An instrument seldom confers benefits with- 
out also involving costs. A dwelling, while it gives shelter, 
compels its owner to assume important costs in keeping it in 
repair, painting it, cleaning it, caring for it, insuring it, and 
paying taxes upon it. A saddle horse yields income to the 
owner when it gives him a pleasure ride, but it requires feeding 



56 ELEMENTS OE ECONOMIC SCIENCE 

and stabling and shoeing, — the negative side of the account, 
constituting the outgo or flow of costs occasioned by the horse. 
A farm produces benefits in yielding crops ; but it requires 
fertilizing, seed planting, and tilling, all of which are costs 
occasioned by the farm. A railroad produces benefits called 
transportation — hauHng passengers and commodities ; but it 
requires an expenditure of money, it burns coal, it demands 
labor ; and these are the outgo, or the negative side of its 
account. 

Costs, too, may be measured in money just as income may 
be measured in money ; and some costs consist in the actual 
expenditure of money, just as some benefits consist in the 
receipt of money. Neither consists of actual money. We 
must therefore distinguish carefully three money items : 
money on hand at an instant of time, which is an example 
of capital ; money received during a period of time, which is 
an example of income (from whatever instrument is the 
means of bringing the money in) ; and money expended 
during a period of time, which is an example of outgo (on 
the part of whatever instrument occasioned the expense.) 

In general, the costs of a given item of capital are out- 
weighed by its benefits. For if it should yield more costs 
than benefits, it would be thrown away, thereupon ceasing 
to be wealth according to definition. Or if it should still 
remain in any one's possession, it might be called negative 
wealth, of which ashes, rubbish, garbage, etc., are familiar 
examples. 

Costs are never voluntarily assumed except in the hope 
of benefits which will make them worth while. The total 
gross income, i.e. the value of the benefits of wealth minus 
the total outgo, i.e. the value of its costs, constitute net 
income. Thus, just as net capital is found by subtracting 
the liabilities from the assets in a capital account, so net 
income in an income account is found by subtracting the 
value of the costs from the value of the benefits. Both 
benefits and costs, however, are attributable to a definite 



INCOME 57 

capital source. In income-accounting the benefits or in- 
come-items are credited to capital, and the outgo or cost- 
items are debited to capital. In keeping income accounts, 
therefore, it is important to know to what category of cap- 
ital any item of income should be credited, or any item of 
outgo debited. 

§ 2. Income Accounts 

We are now in a position to apply the foregoing defini- 
tions to income accounts. We begin by imagining a certain 
" house and lot " as one composite instrument, and shall 
first consider its income and outgo during the calendar year 
1910. The instrument is capital, and the income which 
this capital brings to its owner may be either a money rental 
or the direct shelter and similar benefits of the house enjoyed 
by himself and his family. In either case the income may be 
measured in money, although in the case of occupancy by 
the owner this measurement requires a special appraise- 
ment. The house, let us suppose, was built many years 
ago, and is now nearly worn out. It yields an income worth 
$1000 a year. Against its income there are offsets in the 
form of repairs, taxes, etc., — costs which it occasions. We 
have, then, the following " income account " : — 

Income Account for House and Lot During the Year 

1910 

Income Outgo 

Use of house and lot . $1000 Repairs $200 

Taxes 100 

Insurance 100 

$1000 $400 
The net income is therefore $ 600. 

Next year the house is found to have rotten beams, is 
condemned, and must be abandoned or torn down. Its 
benefits are ended, but the land is still good, and the owner 
can build a new house. The period consumed by this opera- 



58 ELEMENTS OF ECONOMIC SCIENCE 

tion is the first six months of the year 191 1, so that during 
such period there is no income attributable to the house and 
lot, but only outgo. During the second half of the year the 
house is occupied and its use is valued at $600. In the first 
six months not only did the " house and lot " fail to yield 
any income, but it occasioned a cost. This cost was the 
cost of production of the house. 
We have, then, the following account : — 

Inccome Account for House and Lot During Year 1911 

Income Outgo 

Use of house and lot (six Expense of building 

months) $600 house $10,000 

Taxes 100 

$600 $10,100 

Net outgo $9,500 

During this year, then, the house causes a net outgo of 
$9500. All costs are " necessary evils " ; they lead to good, 
though not good themselves ; and this cost of constructing 
the house was incurred only for the sake of resulting future 
benefits. The adverse balance it creates is only temporary 
and will be more than made up in the years which follow. 
For the year 191 2 we have the following : — 

Income Account for House and Lot During Year 191 2 

Income Outgo 

Use $1200 Repairs $ 50 

Taxes 150 

$1200 $200 

Net income $1000 

These figures remain about the same for forty -nine years, 
and give $49,000 net income during that time, canceling 
the excess in cost for 191 1 ($9500) and leaving a large mar- 
gin besides. Then the house is worn out a second time and 
has to be rebuilt. The same cycle is repeated, one year 



INCOME 59 

of excess of cost being offset by forty-nine years of excess 
of income. 

It will be observed that the cost of reconstructing the house 
was entered in the accounts in exactly the same way as re- 
pairs or other '' current " costs. This procedure may seem 
objectionable on the ground that reconstruction is not a part 
of " running expenses " but of '^ capital cost," and should 
therefore belong not to the income account but to the cap- 
ital account. It is true that the value of the new house must 
be entered on the capital-balance sheet, but the cost of pro- 
ducing it belongs properly to the income account. The 
former relates to an instant of time (which may be any 
instant from the time the house is begun till the time when 
it ceases to exist) ; the latter relates to a period of time 
(which may be all or any part of the time during which the 
labor and other sacrifices occasioned by the house occur). 
A house is quite distinct from the series of sacrifices by which 
it was built, although the confusion between the two is 
natural in view of the bookkeeping practice of entering cap- 
ital at its " cost value." The house on which $10,000 was 
expended for construction may be worth either more or less 
than $10,000. In either case the income account should 
contain $10,000 on the outgo side, and the capital account 
a larger or smaller figure, as the case may require. 

Yet we instinctively object to entering the cost of building 
the house in its income-and-outgo account ; and we express 
this objection by calling this cost a " capital cost," rather 
than a part of running expenses. By so classing it we mean 
that it does not recur, or, at any rate, recurs only at long 
intervals. On this basis many persons hold that income 
and outgo should be confined to " regular " items ; and this 
mistaken view seems plausible because in actual practice 
an extraordinary expense in a given year, like the cost of 
constructing a house, does not usually reduce the owner's 
net income for that year by that amount. He will generally 
contrive to avoid such a result by offsetting this extraordi- 



6o ELEMENTS OF ECONOMIC SCIENCE 

nary expense of the house by a corresponding extraordinary 
income from some other source, such as a depreciation fund, 
and other sources to be mentioned later. A depreciation 
fund may have been created by setting aside annually 
throughout the existence of the house a small deposit sufh- 
cient to rebuild the house when it is worn out. The great 
outgo for rebuilding is offset by taking out an equally great 
income from the depreciation fund, and the total net income 
from the " house and lot " and the depreciation fund com- 
bined reveals no radical variation. The depreciation fund 
equalizes the flow of net income from all the property which 
the individual owns. But it does not prevent, it merely 
of sets the large negative balance in the income account of 
the " house and lot " considered by itself. From this single 
source, — the house and lot, — therefore, the net income is 
evidently $1000 a year for each of the forty-nine years, 
and $9500 for the fiftieth year. 

§ 3. Devices for making Income Regular 

Disturbance of income due to building the house may be 
avoided, not only by a depreciation fund, but by other 
devices ; for instance, by paying for the house in install- 
ments ; by borrowing money to defray the cost, and mort- 
gaging the house ; or by selling other property. Another 
method of stead3dng income — and one which ought to set 
at rest any further doubt as to the propriety of the present 
method of accounting — is employed by all accountants 
when the same owner possesses so many of the articles in 
question that the reconstruction of one or another of them 
must occur at short intervals. If a man owns fifty houses, 
each lasting fifty years, and every year one wears out and 
has to be rebuilt, it is then evident that he will have an 
expense of $10,000 every year for the rebuilding of a house, 
which will be a regular item; and he will have a regular 
income balance as a consequence, because he will get the 



INCOME 6 1 

benefit of forty-nine houses, which will far outweigh the 
cost of building only one. The difference will be his net 
income, which will be a fairly regular amount year after 
year. 

Any large group of wealth involves the same principle. 
Professor Clark of Columbia University suggests a helpful 
simile when he compares a stock or fund of capital to a 
waterfall : the drops of water or component parts of the 
waterfall or fund are constantly changing, but the water- 
fall or fund remains about the same. 

§ 4. How to Credit and Debit 

Before leaving the subject of income accounts, we shall 
speak of one particular kind of capital, namely, the 
stock of cash. This will furnish an opportunity to illustrate 
anew some of the principles of bookkeeping which we have 
just discussed. What puzzles the novice in bookkeeping 
is the manner of debiting and crediting a cash drawer. At 
first this m.ay seem to be the opposite of what should be 
done. To understand the practice of accountants in this 
particular is to go a long way toward understanding the 
main principles of bookkeeping. It will help us to under- 
stand it if we liken a cash drawer to a gold mine. We credit 
a gold mine with all the gold extracted, and we debit it with 
all the costs put into it. In the case of the gold mine, what 
it costs to run it is outgo ; all of the yield of gold is gross 
income ; and the difference is the net income. Similarly, 
the gross income from the cash drawer consists of what the 
cash drawer yields, or whatever comes out of it. It benefits 
us whenever it pays our bills ; it costs us whenever we pay 
its bills, i.e. whenever we pay something into it. All the 
payments which we have to make to the drawer are a cost of 
that drawer to us, whereas all the payments that we make 
hy the drawer are the benefits which it produces for us. 
What net benefit, then, does the cash drawer yield in the 



62 ELEMENTS OF ECONOMIC SCIENCE 

long run ? Very little. We pay out just as much as we 
put in ; and if we subtract one amount from the other, the 
net annual income from the cash drawer will be about zero, 
unless during a certain year we store up more than we take 
out, or take out more than we put in. 

The reason that these credits and debits of " cash " seem 
at first the reverse of what they should be is that we are 
accustomed to think of money receipts and expenditures, 
not with reference to the stock of cash into or out of which 
they are paid, but with respect to some other item of wealth 
on account of which the payments are made. If a lodging 
house keeper receives $io from a lodger, she finds it hard 
to debit $io to " cash. " She thinks of the $io as income ; 
and it is income with respect to her lodging house, for the 
latter has yielded it to her. Her stock of cash, however, 
has not yielded it to her. On the contrary, it has taken it 
from her. Later on it will yield it back, and at that time 
should be credited. 

The income from a man's property should be put down 
in his income accounts separately for each item of capital 
he owns, and opposite every such article of capital should 
be put down a credit and debit. Not only should we include 
both positive and negative income, but we should include 
both positive and negative items of capital. The negative 
items are the liabilities. Liabilities yield a net outgo instead 
of a net income. In order, then, to find out the net income 
of any person during a certain day or month or year, the 
proper method is to make a complete statement of all his 
assets and all his liabilities ; and for each asset as well as 
each liability, credit all the benefits and debit all the costs. 
The net result will be the net income of the person. 

A real person will have a net income, but a fictitious per- 
son will not. We have seen, in the case of fictitious persons, 
that there is no net capital because the liabilities always 
equal the assets ; for what is called the capital of a " com- 
pany " really means the capital of its stockholders. As 



INCOME 63 

there is no net capital because the '^ company " owes it all 
to the stockholders, so there is no net income, because the 
" company " pays its all to the stockholders. 

The following is an imaginary income account of a rail- 
road company : — 

Income Account or a Railroad Corporation 



Income 




Outgo 




By passenger and 




To operating expenses 


$800,000 


freight service 


$1,246,147 


To interest to bond- 








holders .... 


100,000 






To dividends to stock- 








holders .... 


200,000 






To surplus applied to 








(i) purchase of land 


140,000 






(2) cash paid into 








treasury . . . 


6,147 



$1,246,147 $1,246,147 

The passenger and freight service yields $1 ,246, 147. That 
is the gross income of the road. All the benefits flowing 
from that road are worth this amount of money. On the 
other side of the railroad account we find the costs of the 
road to the company; they exactly equal the benefits, for 
the company is an abstraction, — a mere holding concern,— 
not a real individual. The outgo consists of operating 
expenses — $800,000; interest to bondholders, $100,000; 
dividends to stockholders, $200,000. The words by and to 
are usual in income accounts. The receipts are benefits, 
and come by virtue of the services designated, and the costs 
represent something which has to be given to these several 
items in order to make the benefits possible. These items 
leave a surplus, partof which is expended for land ($140,000) ; 
this is a cost just as much as anything else. Then there is 
cash left in the treasury to the amount of $6147. It must 
not be concluded that this cash is a net income. The cash 
drawer swallows it up. The company loses $6147, so to 



64 ELEMENTS OF ECONOMIC SCIENCE 

speak, in feeding its cash drawer. Therefore the two sides 
of the account balance, and there is no net income at all. 

§ 5. Omissions and Errors in Practice 

Practically, however, it is not convenient to put in an 
income or a capital account everything which theoretically 
ought to be entered there. Moreover, capital and income 
accounts are not always treated consistently in practice. 
For instance, in a capital account a man would not put in 
his own person, and yet in his income account he will put in 
the money he earns or the work that he does. That is, work 
and wages are put in the incom^e accounts, but the corre- 
sponding items which do this work or earn these wages are 
not put in the capital accounts. The correspondence be- 
tween the two accounts is therefore covered up. On the 
other hand, a man never enters in his income account the 
shelter of his own house as a benefit, and yet he may include 
the house among his assets in his capital account. In ideal 
accounting we should insist upon recording every benefit 
of any kind, every cost, and every source of benefit or cost. 
Adam Smith, the great classical economist, fell into error 
when he said that a dwelling yields no income, but is a source 
of expense. Evidently he had in mind only those costs and 
benefits which come in the form of money payments. We 
certainly get no money benefits by hving in our house, while 
we do suffer a money cost to run it. So far as money re- 
ceipts and expenditures are concerned, therefore, the house 
costs more than it brings in. But no man would keep his 
house if it did not afford him benefits greater than its costs. 
We should therefore appraise the shelter of the house and 
enter this as its gross income. The absurdity of not count- 
ing the shelter of a house as income is particularly apparent 
if we note that Adam Smith, Hke all other economists, in- 
cludes under income the rent or money income that the 
owner gets from a house which is rented. They would 



INCOME 65 

have said that a man who enjoys shelter gets no income, but 
if he gets paid for the shelter enjoyed by another man, he 
does get income. This results in the absurd conclusion that 
if I live in my own house and you live in your own house, 
neither of us receives any income; but if you rent your 
house to me and I rent mine to you, then we shall each be 
receiving income ! Obviously the income is really there all 
the time, in the form of shelter, and when one man rents 
another man's house he gets the shelter-income and gives 
the other man a money-income in its place. 

An account of money received and expended can furnish 
a complete picture of income only when two conditions 
exist ; namely, that all the income is in the form of money, 
and all the outgo is for personal satisfaction. Under these 
conditions the cash drawer and the cash account is a kind 
of money meter of income. These conditions are approxi- 
mately fulfilled when people live in a city and do not own 
their own houses or furniture. Such people get practically 
all of their income from their salaries, dividends, and inter- 
est, all in the form of money receipts. This money is spent 
for benefits, food, clothing, theater going, etc. These 
operations are essentially all. To be sure, the cash drawer 
(or bank account) intervenes between the money-income 
on the one hand — the receipts of salaries, dividends, and 
interest — and the final form into which these are converted 
by expenditure on the other hand; but the bank or cash 
drawer intervenes only as a cogwheel intervenes to transmit 
motion from one part of a machine to another. In strict 
accounting, the bank or drawer should be debited with all 
the money flowing into it from salaries, stocks, and bonds 
and credited with the expenditures. But these opposite 
sums approximately offset and so cancel each other. 

The only method, then, of constructing income and outgo 
accounts which shall be correct and which can serve as a 
basis for economic analysis is the method already indicated 
— the method by which are recorded, for each article of 



66 ELEMENTS OF ECONOMIC SCIENCE 

capital, the values of all its benefits and all its costs. These 
benefits and costs are of many kinds. Sometimes they 
consist of money payments — not in themselves enjoy- 
able to anybody ; sometimes they consist of merely pro- 
ductive operations, and sometimes of truly enjoyable 
elements. All these elements should be entered in the 
accounts on the same footing ; but we shall see that after 
being thus entered they may be so combined that all except 
the " enjoyable " elements will cancel among themselves. 



CHAPTER V 

ADDITION OF INCOME 

§ I. " Methods of Balances " and " Couples." 
^* Interactions " 

We have now learned how to reckon the income of either 
a real or a fictitious person. Of reckoning the income of 
society there are two ways, corresponding to the two ways 
of reckoning society's capital ; i.e. the method of balances 
and the method of couples. The method of balances is very 
easy to understand. All that is necessary is to make up an 
income account for any given period for each instrument or 
each owner so as to include all possible income or outgo in 
the society under consideration and, taking from each in- 
dividual account the net balance, add these net results to- 
gether. The result is the total income of society. Its con- 
stituent parts are the net incomes from each instrument or 
owner in society. 

The " method of couples " is somewhat more difficult to 
follow. But it is also more important. Just as the same 
item in capital accounts is both asset and liabiHty, according 
to the point of view, and is therefore self-canceling, so the 
same item in income accounts is both benefit and cost, and 
is, therefore, Hkewise self-canceling. In fact, the reader may 
have felt that, in many of the examples cited, what we called 
costs were really benefits. He may have asked himself: 
Why should we call rebuilding a house a cost? When a 
carpenter and his tools repair it, do we not credit him and 
them with a service performed? Is not any production a 
benefit? Have we not, then, placed repairs on the wrong 

67 



68 ELEMENTS OF ECONOMIC SCIENCE 

side of the ledger ? It depends upon which of two accounts 
we are considering. When a carpenter with his plane, ham- 
mer, and saw helps to rebuild a house, we have to consider 
two groups of capital. One group, the carpenter and tools, 
is acting on the other group, the house. The carpenter and 
tools certainly perform a service or benefit, but the house 
does not. Considered as occasioned by the house, the re- 
pairs are costs. The house absorbs or soaks up these costs, 
promising to compensate for them by benefits to be yielded 
later on. The renaiiing of loose shingles is certainly not 
what the house is for ; with respect to the house, it is a nec- 
essary evil ; with respect to the hammer, however, it is a 
service rendered. Therefore the repairing of the house is at 
once a benefit and a cost. 

Such double-faced events are so important as to require a 
special name. We shall call them interactions between two 
instruments or groups of instruments. 

An interaction, then, is a benefit or service of the acting 
instrument, and a cost or disservice of the instrument acted 
on. There can never arise the slightest doubt as to when it 
is to be regarded as positive and when negative. The 
definitions of benefit and cost settle this question in each 
case by referring it to the desire of the owner. Since the 
house owner desires that the house should not occasion re- 
pairs, these repairs are costs of the house ; and since the 
tool owner desires that the tools should occasion repairs, 
such repairs are the benefits of those tools. 

The example given is typical of the general relations be- 
tween interacting instruments. The mental picture we 
should construct is that of two distinct groups of capital. 
Group A acts on, and so to speak, benefits Group B. What- 
ever the nature of this interaction, A is credited with it as a 
benefit and B is debited with it as a cost. These two items 
of credit and debit are equal and simultaneous. 

Interactions involving this mutual cancellation constitute 
the great majority of the elements which enter into income 



ADDITION OF INCOME 69 

and outgo accounts. The only benefits which are not 
merely the positive side of such canceling interactions are 
satisfactions — desirable conscious experiences — often mis- 
called '' consumption " ; and the only costs which are not the 
negative side of such canceling interactions are " labor and 
trouble." But these two final elements — " satisfactions " 
on the one hand and '' labor and trouble " on the other — • 
are only the outer edges of the series. Between them is a 
connective chain of repoductive processes and commercial 
transactions, every link of which has two sides, a positive side 
of benefits or services and a negative side of costs, always 
self-cancehng. 

§ 2. Interactions which change the Form or Position of 
Wealth (Production and Transportation) 

The interactions between two articles or groups of articles 
are of three chief kinds : changes in the form of wealth, 
changes in the position of wealth, and changes in the owner- 
ship of wealth ; in other words, transformation, transpor- 
tation, and transfer or exchange. These we shall take up 
in order, and show how each is an interaction, two-faced. 

First, what is here called transformation of wealth is 
practically identical with what is usually understood by 
'' production " or " productive processes." By this trans- 
formation of wealth, or changes in its form, is meant the 
changes of relative position of its parts. Weaving, for 
instance, is the transformation of yarn into cloth by a re- 
arrangement in the relative position of the warp and woof. 
Spinning, likewise, consists of moving, stretching, and 
twisting fibers into yarn ; sewing, of changing the position of 
thread so that it may hold cloth together ; and so it is with 
carding, wool sorting, shearing, and all the other operations 
which constitute the manufacture of fabrics. All these — 
all manufacture and all agriculture — consist simply of a 
series of transformations of wealth, each transformation 



70 ELEMENTS OF ECONOMIC SCIENCE 

two-faced. On the part of the transformed instrument or 
instruments the transformation is a cost ; on the part of the 
transforming instrument or instruments it is a benefit. So 
it is, not only when a carpenter and his tools build or repair 
a house but also when the painter decorates it or the janitor 
cleans it, or when a cobbler transforms leather into shoes, or 
when a bootblack transforms dirty shoes into clean and 
pohshed ones, or when a loom produces cloth out of yarn, 
or when land renders a service in producing wheat. 

The principle is not altered when the interaction consists 
not in producing a change but in preventing one. A ware- 
house renders its service as means of storing bales of cotton, 
i.e. protecting them from the elements ; and this storage is, 
on the part of the stock of cotton, an element of outgo, or ex- 
pense, as on the part of the warehouse it is an item of income. 

Nor is the principle altered when there are, as is indeed 
usually the case, more articles than one in either or both of 
the two interacting capitals. Plowing, or the transformation 
of land into a furrowed form, is performed by a plow, a 
horse, and a man. The plowing is a cost debited to the land 
on the one hand, and at the same time a service credited to 
the group of capital consisting of the plow, horse, and man 
on the other. 

Nor is the principle altered if one or more of the trans- 
forming agents perish in the transformation and another 
comes for the first time into existence. Bread making is a 
transformation debited to the bread and credited to the cook, 
the range, the flour, and the fuel, of which the last two are 
consumed as soon as they perform their services. Agents 
which disappear in the transformation, but reappear in whole 
or in part in the product, are called '' raw materials." The 
production of cloth from yarn is a transformation effected 
by means not only of the loom but also of a number of other 
agents, among them the yarn itself, which thus vanishes as 
yarn and reappears as cloth. The cost of weaving, includes 
as cost this consumption of raw material — yarn; and 



ADDITION OF INCOME 71 

this consumption of yarn, on the part of the yarn itself, is 
not cost but service. It is the use for which the yarn existed. 
When cloth is turned into clothes, this transformation is a 
service to be credited to the cloth, and a cost to be debited 
to the clothes. All raw materials yield benefits as they 
are converted into finished products. Their conversion is, 
however, on the part of these products, always outgo and 
not income. 

In this way, when an article passes through various stages 
of production, the designation of these stages is often an ar- 
bitrary matter. A " sapKng " grows into a ''tree". We 
may, if we choose, consider the sapKng as one category and 
the tree as another. In this case the " saphng " yields a 
benefit the moment it becomes a " tree " ; but no effect on 
social income is produced, because, if we credit the sap- 
Kng with the value of the tree, we must debit the tree 
with the cost of the sapling. Likewise we may arbitrarily 
designate the moment when a " calf " becomes a '' cow," 
or when '' new " wine becomes " old," without disturbing the 
income amounts of society ; for such events are always two- 
faced and cancel themselves out in the total. We may, in 
fact, mark any stage whatever in the course of production by 
an arbitrary line, and regard the passage across this line as 
a service on the part of the capital on one side of the line — 
the earlier side — and a cost on the part of the capital on the 
other side. 

A closely related class of interactions is transportation, or 
changes in the position of wealth. It is a very shght dis- 
tinction which separates this class from the preceding class. 
Transforming or producing wealth consists of changing the 
position of its parts as related to each other ; transporting 
wealth consists of changing the position of that wealth as a 
whole. But " part " and " whole " are themselves loose and 
relative terms. Bookbinding is a transformation or pro- 
duction of wealth ; it assembles the paper, leather, thread, 
and paste into a whole book. DeHvering the finished book 



72 ELEMENTS OF ECONOMIC SCIENCE 

to a library is transportation. Yet the library is, in a sense, 
a whole ; and to assemble books into a classified and organ- 
ized library is to make a whole out of parts. The distinction 
between transformation and transportation is thus merely 
one of convenience. Many writers prefer to include them 
both under " production." We prefer to include them under 
the less ambiguous and more inclusive head of " interac- 
tions," and our object here is not to emphasize their difference 
but their similarity. The same principle of equal and oppo- 
site services apphes to both. The following are examples of 
transportation : When merchandise is transmitted from one 
warehouse to another, the first warehouse is credited with 
the change and the second debited. The warehouse which 
has rendered up the merchandise has done a service ; that 
which has received it is charged with a cost. A banker who 
takes money from his vault and puts it in his cash drawer 
will, if he keeps separate accounts for the two, credit the 
vault and debit the till. When wheat is imported from 
Canada, that nation is credited, and the United States is 
debited, with the value of the wheat. As in the case of 
continuous productive processes, so in the case of continuous 
transportations, we may divide up transportation districts 
by arbitrary Hnes, and consider the passage of any articles 
across those hnes as interactions. 

§ 3. Interactions which change the Ownership of Wealth 
(Exchange) 

The third class of interactions is the change of ownership 
of wealth or of property. This has been called transfer. 
Transfers usually occur in pairs, and involve two objects 
transferred in opposite directions between two owners. This 
double transfer we have called an exchange. Since an ex- 
change consists of two transfers, and since a transfer is a 
species of interaction and as such is self-cancehng, every 
exchange is self-canceling and cannot of itself contribute 



ADDITION OF INCOME 73 

anything to the total income of society. When, for instance, 
a bookseller sells a book, he credits his stock with the fact 
that it has brought in money, and the customer debits his 
library to the same amount. 

These two items constitute the transfer between the stock 
of books of the dealer and the stock of books of the customer. 
The remaining two items constitute a transfer between the 
stocks of cash of the two men ; the dealer debits his " cash " 
and the customer credits his. 

When, therefore, an article of wealth changes hands, 
whether it be money or something else, it occasions an ele- 
ment of income to the seller and an element of outgo to the 
purchaser, and therefore no income at all to society. The 
effect of canceling these items — the credit item of the seller 
and the debit item of the purchaser — is to free the income 
account of that article from all entanglements with exchange, 
to wipe out all money-income, and to leave exposed to view 
the " natural " income of the article. Thus books 3deld their 
natural income, not when the book dealer sells them, but 
later when the reader peruses them. The sale is a mere pre- 
paratory service, a credit item to the book dealer and a debit 
item to the buyer. Again, a forest of trees yields no natural 
income until the trees are felled and pass into the next stage 
of logs. The owner of the forest may, to be sure, ''realize" 
on the forest long before it is ready to be cut, by simply 
selKng it to another ; and to him the forest has then yielded 
income ; but, as the purchaser has suffered an equal outgo, 
the net result of this interaction, as of every other, is zero. 

The rent of a rented house is, for society, not income at 
all. It is income to the landlord but outgo to the tenant — • 
outgo which he is wiUing to suffer solely because of the shelter 
he receives. This shelter alone remains as the income from 
the house after the rent transaction is canceled out between 
the two parties concerned. The shelter-income is the es- 
sential and abiding item, and without it there could be no 
rent-income to the landlord. 



74 ELEMENTS OF ECONOMIC SCIENCE 

Again, a railway )delds as its natural income solely the 
transporting of goods and passengers. Its owners sell this 
transportation service for money, and regard the railway 
simply as a money maker ; but to the shippers and passen- 
gers this same money is an expense, and exactly offsets the 
railway's money earnings. Of the three items — money-in- 
come of the road, money-outgo of its patrons, and transpor- 
tation — the first two mutually cancel and leave only the 
third, transportation, as the real contribution of the railway 
to the sum total of income. 

We see, then, that the method of couples, appHed to buyer 
and seller, denudes all capital of its so-called '' money-in- 
come," and lays bare the only income it can naturally pro- 
duce. We see that capital is not a money-making machine, 
but that its income to society is simply its services of 
production, transportation, and gratification. The income 
from the farm is the yielding of its crops ; from the mine, 
the production of its ore ; from the factory, its transforma- 
tion of raw into finished products ; from commercial capital, 
its passage of goods from producer to consumer; from 
articles in consumers' hands, their enjoyment or so-called 
" consumption." 

Similar principles apply to outgo , no part of which, for 
society, occurs in money form. The great bulk of what 
merchants call " cost of production," expense, or outgo, 
consists of money costs which, as concerns society, carry 
with them their own cancellation. For manufacturers, 
merchants, and other business men, almost every outgo is an 
expense, i.e. consists of a money payment. Such money 
payments are for wages, raw materials, rent, and interest 
charges, all of which are incomes for other people. The 
wages are the earnings of labor; the payment for raw 
material is received by some other manufacturer ; the rent 
is received by the landlord ; the interest charges by the 
creditor. 



ADDITION OF INCOME 75 

§ 4. Accounts illustrative of so-called Production 

Not only do exchange transactions completely cancel 
themselves out in reckoning total income, but the great 
majority even of the natural benefits of capital do the same. 
Even these natural benefits of capital consist for the most 
part of *' interactions " ; they are transformations or trans- 
portations of wealth. They are intermediate stages, merely 
preparatory to the final enjoyable benefits of wealth, and, 
after the interactions have been canceled out, do not enter 
as items either on the income or outgo side of the social 
balance sheet. 

In order to show the effect of canceling out the equal 
and opposite items entering into every interaction through- 
out all productive processes, let us observe the various 
stages of production which begin with the forest above re- 
ferred to. The product of the forest, its gross income, is the 
series of events called the turning out of logs. This log pro- 
duction is a mere preparatory service, a credit item to the 
forest and a debit item to the stock of logs of the sawmill, 
to which they next pass. As the sawmill turns its logs into 
lumber, the lumber yard is debited with the production of 
lumber, and the sawmill is credited with its share in this 
transformation. Intermediate categories may, of course, 
be created, and we may follow, in like manner, the further 
transformation, transportation, and exchange to the end of 
the stages of production, — or rather, to the ends ; for these 
stages spHt up and form several streams flowing in differ- 
ent directions. To follow only one of these streams, let us 
suppose that the lumber which goes out from the yard is used 
in repairing a certain warehouse. The warehouse is used 
for storing cloth ; the cloth goes from the warehouse to the 
tailor; the tailor converts the cloth into suits for his cus- 
tomers ; and his customers receive and wear those suits. 
In this series, all the intermediate services cancel out in 
" couples " and leave as the only uncanceled element, or 



76 



ELEMENTS OF ECONOMIC SCIENCE 



final fringe of services, the use of clothes in the consumers' 
possession. 

Should we stop our accounts, however, at earlier points 
in the series, the uncanceled fringe at which we should find 
ourselves would be not consumers' services, but the positive 
side of some intermediate service or interaction whose nega- 
tive side would not appear, as it would belong to a later stage 
in the series. These facts will be clear if we put the matter 
in figures, stage by stage. The following are the items for 
the logging camp above mentioned, in the accounts of its 
owner : — 



Income Account for Logging Camp 


Income 


Outgo 


Production of logs .... $50,000 


(Omitted) 



The gross income from the logging camp, considered by 
itself, and without any deductions for expenses, is here seen 
to consist in the production of $50,000 worth of logs. If, 
however, we combine the logging camp with the sawmill, we 
shall have accounts Kke the following, in which, to avoid 
irrelevant compHcations, no account is taken of any expenses 
which do not happen to be interactions between the groups 
of capital considered : — 

Income Account for Logging Camp and SAwaoLL 



Capitai, Source- 


Income 


Outgo 


Logging camp . . . 
Sawmill 


Yielding logs to saw- 
mill . . . $50,000 
Yielding lumber to 
lumber yard $60,000 


Receiving logs from 
camp . . $50,000 



In this case, canceHng the two log items, we have left only 
the lumber item ; i.e. the income from the combined logging 



ADDITION or INCOME 77 

camp and sawmill consists only of the production of lumber, 
its final product. The transfer of logs from one department 
to the other no longer appears. This transfer is like the 
taking of money from one pocket and putting it in another, 
— a fact which would be particularly evident in case the 
logging camp and sawmill were combined under the same 
management. 

Extending the sam^e principles to the entire series, we 
have the accounts as given in the table on the next page. 

In this table we may successively cancel each pair of items 
constituting an interaction. An item on the left is the posi- 
tive side of an interaction of which the item on the right in 
the hne next below is the negative side. Thus, the $50,000 
in the first Hne on the left cancels the $50,000 in the second 
Hne on the right. Similarly, the two item^s of $60,000 cancel 
in the fines next below, respectively. If we stop after the 
first two cancellations, using only the first three fines of the 
table, we shall find that the net income from logging camp, 
sawmill, and lumber yard consists only of the production of 
retail lumber, $70,000 ; it does not include either the trans- 
fer of logs or the transfer of wholesale lumber. In like 
manner, if we proceed one stage further, that is, if we stop 
our cancellations at the end of the first four interactions, 
the production of retail lumber no longer appears as an ele- 
ment of income ; and so on, step by step to the end, when 
the only surviving item will be the ^' wear " of the suits. 

It is, of course, true that in any actual accounts there will 
be other items besides those which have been exhibited in 
this simple, chainlike fashion. Were it worth while, we 
might insert these additional entries of income and outgo 
elements. Most of them would likewise consist of the posi- 
tive or negative side of interactions ; and if we were to intro- 
duce their respective mates, the opposite aspects of the same 
transactions respectively, it would be necessary to include 
the accounts of still other instruments. If we should follow 
up aU such leads, we should soon have instead of the simple 



78 



ELEMENTS OF ECONOMIC SCIENCE 



o o 

o o 

o o 

o" d 

lO vo 

«©= 
a 

^ B 



o o 

o o 

o o 

o" d 

t^ 00 



S -^ 

O 5-1 

bO bO 

B B 

[> V 

(U (U 



II 

ba 2 



bO bO 



P^ PiJ 



bC 






bC bO 

B B 



flj 


• 




• 










o 


^ 




C/3 


,d 


+-> 




<U 


^ 




o 


i • 


^ 


3 


c^ 


4-> 


o 


>-i 


-(-> 


R ^" 



a 



cu o 



1> T1 P - 



c« 



bO bO bO 

• S .S .B 

2 2 3 

'oj T) 'o 



>H |>H ^ >H >H >H 



a 

u 

bO 

*bi) 
bO 
O 

H-1 



i i ^ 

c/2 t-^ 5> 



rS O 



o 

"o '^ '^ 

^J O o 

^ ^ ^ 

U CJ u 

o o o 

C/2 C/2 C/2 



ADDITION or INCOME 79 

chain represented in the table, an intricate network of re- 
lated accounts. But the same principle of the interaction as 
a self-effacing element would apply. 

§ 5. Preliminary Results of combining these Income 
Accounts 

The table given will throw Hght on the question : Of what 
does income consist ? This question is not a thoroughly defi- 
nite one. But if we ask instead : Of what does the income 
from a particular group of capital consist ? we shall make the 
question definite. Whether the production of logs is in- 
come or not depends upon the point of view. It is income 
from the first link of capital in our series (the logging camp) ; 
it is not income from the first two links combined, for in the 
second link it occurs as outgo. Likewise, the use of the 
warehouse is income with respect to the first four links of 
capital, but is not income with respect to the first five 
hnks. 

We see, therefore, that in reckoning up the income from 
any group of capital we may as well omit all interactions 
taking place within it, and confine ourselves to the outer 
fringe of services performed by the group as a whole. As 
the group is enlarged, this particular outer fringe disap- 
pears by being joined to the next part of the economic fabric, 
and another still more remote fringe appears. The question 
then arises : When is the economic fabric complete, and has 
it any final outer fringe? But the answer to this question 
must be postponed. 

Contrasting the method of couples with the method of 
balances, we may say that the method of couples is useful in 
showing of what elements income consists in any given case. 
The method of balances, on the other hand, is useful in ex- 
hibiting the amount of income contributed from each capital 
source. The two methods, as applied to the example just 
given, are as follows : — 



8o 



ELEMENTS OF ECONOMIC SCIENCE 



Method or Balances 



Capital Income 


OtrrGO 


Net Income 


Logging camp $ 50,000 

Sawmill 60,000 

Lumber yard 70,000 

Warehouse 80,000 

Stock of cloth in warehouse 90,000 
Stock of cloth of tailor . . 100,000 
Stock of clothes of customers 1 1 0,000 


$ 50,000 
60,000 
70,000 
80,000 
90,000 
100,000 


$ 50,000 
10,000 
10,000 
10,000 
10,000 
10,000 
10,000 




$ 110,000 



Method of Couples 



Income 


Outgo 


$ 50,000 




60,000 


$ 50,000 


70,000 


60,000 


80,000 


70,000 


90,000 


80,000 


100,000 


90,000 


110,000 


100,000 



The two methods — balances and couples — show the 
same result, but from different points of view. By means 
of the method of balances we are enabled to see what part of 
the final net income is contributed by each of the articles in 
the group. By means of the method of couples, we are en- 
abled to see of what the net income from the entire group of 
articles consists; canceling by the oblique lines, we have left 
but one item, $110,000, representing the " wear" of the suits. 

The two methods must not be confused. When we find 
by the method of couples that the net income of $110,000 
consists exclusively of the use of suits of clothes, this does 
not by any means imply that this net income is all of it due 



ADDITION OF INCOME 8 1 

to the stock of clothes. To discover to what it is due re- 
course must be had to the method of balances. We then see 
that only $10,000 of it is due to the stock of clothes, the re- 
mainder being due to the other capital instruments in the 
table, which made the clothes possible, and most of all 
($50,000) to the logging camp. Combining the results of 
both methods, we may state that the total net income from 
the specific group of instruments consists of $110,000 worth 
of " wear " of suits and that this is due partly to the stock of 
clothes and partly to other capital. Of course our table 
does not give all the capital to which the wear of the suits is 
indebted. We have, as already noted, omitted for the sake of 
simphcity all items of cost which do not belong to our chosen 
series. But the inclusion of other items, while it complicates 
the accounts, does not change the principle of cancellation. 
It merely introduces other chains of interaction. 

The two methods correspond in a general way to the two 
methods for canceling habilities and assets in capital ac- 
counts. The method of balances gave, it will be remem- 
bered, the amount of capital belonging to each individual; 
the method of couples showed of what elements the total 
capital consists. 

§ 6. Double Entry in Accounts of Fictitious Persons 

We have now followed the cancellations to which inter- 
actions lead, whether they be interactions of exchange or of 
production. The case of exchange, however, needs further 
consideration. Since every exchange consists of two trans- 
fers, and every transfer of two items, a credit and a debit, 
the exchange evidently consists of four items in all, two of 
which are credits and two of which are debits. These four 
may be paired off in two ways, only one of which has thus far 
been mentioned. They stand, as it were, at the four corners 
of a square, as in the following scheme, which shows the 
credits and debits involved when goods worth $2 are sold. 



82 



ELEMENTS OF ECONOMIC SCIENCE 



The dealer credits his stock of goods and debits his " cash/' 
while the buyer does the opposite. 





Stock op Goods 


Stock of Cash 


Seller 


+ $2 


-$2 


Buyer 


-$2 


+ $2 



The two transfers into which any exchange may be re- 
solved are represented by the two columns of the table. But 
an exchange may also be resolved into two pairs of items 
represented by the twa horizontal Hnes of the table. The 
items in the same horizontal line record the part taken in the 
exchange by one of the two persons participating in it. 

Every exchange, then, consists of four items, and may be 
resolved either into two transfers (one for each property 
exchanged) or into two transactions (one for each party to 
the exchange). The first resolution has been considered; 
we proceed now to the second. 

The following account represents the entries during a given 
year for a dry goods company. In this account we observe 
that every item on the incom^e side is balanced by an equal 
and opposite item on the outgo side. All items thus paired 
are represented by the same letters, the capitals being used 
for positive items and the small letters for negative. 

Income and Outgo of Dry Goods Company for iqio 



Capitax Source 


Income 


Outgo 


Stock of goods 


By Goods sold $io,ooo A 


To goods bought $5,000 b 


Cash .... 


By cash taken out for: 
Purchases $ 5,ooo B 
Profits . $2,oooC 


To cash received from 

sales ... $ 10,000 a 


Capital Stock . 




To profits paid $ 2,000 c 



ADDITION OF INCOME 83 

The rule we have learned in Chapter IV for making com- 
plete income accounts is to start with the capital account, 
taking each item of assets and each item of liabilities, and 
to enter for each item of either kind all the items of income 
to which they give rise — plus or minus. For simplicity, 
it is assumed that, instead of fifty or one hundred different 
items of capital, there are only three items ; namely, the 
stock of goods, the stock of cash, and the '' capital stock," 
which is a iiabihty item. The stock of goods yields $10,000 
worth of sales. But, on the other hand, it costs $5000 to 
replenish this stock of goods. Therefore it is credited with a 
plus item of |io,ooo, and debited with a minus item of 
$5000. The student will notice that each item is entered 
twice, once on each side. This " double entry " is a nec- 
essary feature of the income accounts of fictitious persons, 
and has long been observed in practical accounting. It fol- 
lows that the doubly entered items may be mutually can- 
celed, A cancels with a ; that is, though the stock of goods 
are credited with bringing in $10,000 (A) in cash, the cash 
drawer must be debited with the $10,000 (a) which it swal- 
lows up. Likewise the stock of goods costs $5000 (b) , which 
must therefore be debited to it ; but the cash drawer has to 
supply the $5000, and is therefore credited with 5000 (B), 
so that item B cancels with b. Finally, when the profits are 
paid, they also come out of the cash drawer, and the cash 
drawer is credited with exactly that amount, $2000 (C), 
while the capital stock is debited with that amount as a cost 
(c). So we see that all items cancel each other in pairs. 
The two sides of the account of such a fictitious person nec- 
essarily balance. Even if the company accumulates its 
profit instead of paying it to the shareholders, the two sides 
still balance ; for, as has been seen, the money thus received 
is then debited to the cash account. 



84 



ELEMENTS OF ECONOMIC SCIENCE 



§ 7. Double Entry in Accounts of Real Persons 

In the case of real persons, however, the two sides do not 
balance, for the accounts do not then consist solely of double 
entries. To show this, let us consider the accounts of a real 
person as given in the next table. In these accounts, as 
in the previous ones, which are much simplified, we have 
indicated the like items on opposite sides by like letters, the 
positive items being represented by capitals and the negative 
by small letters. We observe that, as in the corporation 

Income and Outgo of a Real Person 



Capitai, Source 


Income 


Outgo 


Stocks and bonds 


Receipt of money from 
stocks and bonds $2000 A 


Money expended 
for stocks and 
bonds . $ 500 d 


Lease right . . 


Shelter .... $ 100 [5] 


Money rent paid 
. . . $ 100 e 


Food . . . . 


Use of food . . . $ i5o[C] 


Money cost of 
food . . $ 150 / 


''Cash" . . . 


Paid out for bonds $ 500 D 
Paid out for rent . $ 100 £ 
Paid out for food . $ 150 F 


Receipt of money 
from stocks and 
bonds . $2000 a 

Receipt of money 
for work done 
. . . $2000 g 


Self 


Receipt of money for work 
done .... $ 2000 G 





Uncanceled items : Shelter [B] . . $ 100 
Use of food [C] $ 150 



ADD nON OF INCOME 85 

accounts, many of the items will " pair." But, unlike cor- 
poration accounts, the present accounts contain a residue of 
items which will not pair. The letters representing these 
unpaired items are designated by being inclosed in square 
brackets. They show that [J5] and [C] — the shelter of 
the house, and the use of food — constitute a kind of in- 
come which does not appear elsewhere as outgo. 

When studying the accounts of instruments, we found in 
considering the chain of productive services of a lumber 
camp, etc., that there always remains some outer fringe of 
uncanceled income. We have now reached this same kind 
of outer fringe in studying the accounts of persons, provided 
they are real persons. This outer fringe consists of the final 
benefits of their instruments. All other items are merely 
interactions preparatory to such final benefits, and pass 
from one category of capital to another. Thus the income 
from investments, being deposited in bank, is outgo with 
respect to the bank account; the bank account yields in- 
come by paying for stocks and bonds, food, etc., but in each 
case the same item enters as outgo with respect to these or 
other categories of capital. In all these cases the individual 
receives no income which is not at the same time outgo. It 
is only as he consumes the food, wears the clothes, or uses 
the furniture, that he receives income. And these final 
benefits are, of course, the end and goal of all the preceding 
economic processes and activities. 

§ 8. Final Enjoyable Income 

The stage at which we have just left income may be called 
the stage of final objective services. In other words, it is 
the stage at which the wealth of the objective world at last 
acts upon the physical person of the recipient. This fimal 
objective income is that of which the economist is usually in 
search, and is that which the ordinary statistics of working- 
men's expenditures represent. It is clear from what has been 



86 ELEMENTS OF ECONOMIC SCIENCE 

said, that in the final net income which we derive from wealth 
all interactions between different articles of wealth drop 
out, — all the transformations of production, such as the 
operations of mining, agriculture, and industry, all the 
operations of transportation, and all business transactions 
or exchanges. For in all such cases the debits and credits 
inevitably occur in pairs of equal and opposite items. Each 
pair consists of the opposite facets of the same interaction. 
The only items which survive are the final personal uses of 
wealth. Let us call these the last benefits outside ourselves. 
Examples of such benefits are benefits of nourishment, bene- 
fits of housing and warming, benefits of clothing, benefits of 
personal attendance. 

But the economist, in his analysis, must not stop here — 
outside ourselves. There is one step more before the pro- 
cess is complete. Indeed, no benefits outside ourselves 
are of significance to us except as they lead to satisfactions, 
and these can only exist within our minds. 

Now these final benefits come to our minds through our 
bodies. No agent outside the body can yield them. All 
that persons or things outside of man can do is to stimulate 
his bodily organism. What are called benefits of amuse- 
ment or instruction cannot amuse or instruct the mind save 
through bodily agencies. An '' instructive book," for in- 
stance, is powerless to instruct. It can render its benefit 
simply and solely by reflecting hght into the eye of the 
reader. It is necessary that these stimuH on the optic nerve 
should be transmitted through the nervous system and 
brain before any mental instruction takes place. So a piano 
can of itself produce no sensations of tone. It merely pro- 
duces vibrations outside ourselves which, through the ear and 
auditory nerve, ultimately result in sensations within us. 
All sound, sight, taste, smell, touch, come about through 
reactions of the nervous system to stimuh. We must, 
therefore, to make our accounts complete and final, include 
the debits and credits of our own persons. When we do so, 



ADDITION OF INCOME 87 

we immediately see that, just as the credits of the logging 
camp are the debits to the sawmill, so the credits of our outer 
possessions are really the debits of our bodies. A man who 
receives a Turkish bath must credit the bath to the water, 
towels, attendants, and other cooperating agencies by which 
he gets it, but he must debit his body with the bath as one of 
the costs his body occasions him. The bath is simply an 
interaction, between the towels, etc., and his body. Like 
all interactions, their purpose is that later there may be ex- 
perienced pleasant sensations or the avoidance of unpleasant 
ones, in this case the exhilaration and enjoyment of good 
health. Similarly, the use of clothing and shelter leads ul- 
timately to the prevention of the sensation of cold, but their 
immediate service is simply to hinder the dissipation of heat 
from the body. They are costs of the body, just as the care 
and protection of a horse are costs of the horse. 

Likewise medicine is a cost to the body. Its services are 
(or are supposed to be) the repairing of the body, and, 
although credited to the medicine, should be debited to the 
body, just as the services of a carpenter are credited to him 
but debited to the house which he mends. The " consump- 
tion," or use of food, though it is a service of the food, is a 
disservice of the body ; for food stands in the same relation 
to the body as fuel to a furnace or repairs to a house. The 
final income consists of the subjective satisfaction of the 
appetite and the other satisfactions which the taking of 
food enables the body to yield to the mind. These include 
not simply the immediate gratification of the palate, but the 
promotion of pleasant sensations or the avoidance of un- 
pleasant ones later on. In other words, the consumption 
of food, by preserving health and maintaining life, enables 
the body to yield'better and longer-continued service to the 
mind in future years, just as the repairs on a house enable it 
to yield shelter a long time after the repairs are made. 
These and other illustrations will show that, if we include 
the body as a transforming instrument, while we must credit 



88 ELEMENTS OF ECONOMIC SCIENCE 

with their respective services all these outside agencies, such 
as food, clothing, dwelHngs, furniture, ornaments, and other 
articles which, as it were, bombard a man's sensory system, 
we must at the same time debit the body with these same 
items. The benefits or services of food, clothing, houses, 
still lie outside ourselves. But when they come to be 
actually used to satisfy wants, they are translated, as it 
were, into subjective benefits ; i.e. into something inside 
the human mind. After this point, income can be expressed 
only in terms of human consciousness, having passed the 
threshold of the outside, objective world. 

The only surviving credit items, after these equal debits 
and credits are canceled, are the resulting final satisfactions 
in the mind. In other words, in order that the external 
world should become effective to man, the human body 
must be considered to be the last transforming instrument. 
Just as there is a gradual transformation of services through 
the farm, flour mill, and bakery, so is there a final trans- 
formation within the human body itself. It is a sort of fac- 
tory, the products of which are the only final uncanceled 
income of the consumer. In a complete view of productive 
processes, the human machine is no more to be left out of 
consideration than machines which handle the wheat in its 
prior stages. 

All objective income is then entirely erased or negatived 
as soon as we apply our accounting to the body of the recip- 
ient. The benefits of which that income consists empty 
out, as it were, into the human body, but the ultimate result 
is not actually felt until it appears in the stream of con- 
sciousness. 

Final income, then, is simply the stream of consciousness 
of any human being. All his conscious Hfe, from his birth 
to his death, constitutes his subjective income. Sensa- 
tions, thoughts, feehngs, volitions — in fact, all mental 
events — are a part of this income stream. All conscious ex- 
periences which are desirable are positive items of income; 



ADDITION OF INCOME 89 

they are final benefits. All which are undesirable are nega- 
tive items; they are costs. 

When we say that mental satisfactions are the goal of all 
economic processes, we mean that they are the object at 
which men aim. In the deeper economy of the universe 
these satisfactions may, in turn, be the beginning of more 
important chains of events. But economic analysis ends 
with the motives which actually sway men's actions, not 
with ultimate consequences of their acts. The satisfaction 
of the desire for food should lead to the preservation of the 
individual, but it may lead to the impairment of his health. 
The satisfaction of the sexual appetite should lead to the 
preservation of the race, but it may lead to its degradation. 
Nature, or natural selection, seems to have implanted many 
appetites merely as baits to serve ulterior purposes. But to 
the individual the satisfaction of these appetites may be the 
farthest end he individually has in view. Whatever is the 
ultimate end in view for the satisfaction of the individual's 
desires is then " final " only so far as our present analysis 
is concerned. 

We have now reached a convenient place in which to em- 
phasize a point of great importance, but one which is seldom 
understood, namely, that most of what is called '' cost of 
production " is, in the last analysis, not cost at all. We 
have found, in using the method of couples, that every item 
of cost outside ourselves is also an item of income, and that 
in the final total no such items survive cancellation. It costs 
the baker flour to produce bread ; but the cost of flour to the 
baker is income to the miller. To society as a whole it is 
not cost nor benefit, but a mere interaction. Similarly of 
wages ; the employer counts his pay roll as cost of produc- 
tion, but the laborer counts it as earnings. To society as a 
whole, wages are neither cost nor benefit. 

In the last analysis payments of wages, interest, rent, or 
any other payments from one member of society to another 
must not be thought of as costs to society as a whole. This 



go ELEMENTS OF ECONOMIC SCIENCE 

fact should now be clear ; yet it is commonly overlooked. 
When people talk of the cost of producing coal or wheat, 
they usually think of money payments. The only ultimate 
item of cost is labor cost, or if the term " labor " be not suf- 
ficiently broad, labor, anxiety, trouble, annoyance, and all 
the other mental experiences of an undesirable nature which 
are undergone in order that mental experiences of an agree- 
able nature may be secured. Perhaps the best term to com- 
prise the undesirable feelings undergone for the sake of gain- 
ing desirable f eehngs later on is the term ' ' efforts . ' ' We may 
conclude, therefore, that in the last analysis income consists 
of satisfactions and outgo of e forts to secure satisfactions. 
Between efforts and satisfactions may intervene innumer- 
able interactions, but they all must cancel out in the end. 
They are merely the machinery connecting the efforts and 
satisfactions. At bottom, economics treats simply of ef- 
forts and satisfactions. This is evident of an isolated 
individual like Robinson Crusoe, who handles no money ; 
but it is equally true of the most highly organized society, 
though obscured by the fact that each member of such a 
society talks and thinks in terms of money. 



CHAPTER VI 

CAPITALIZING INCOME 

§ I. The Link between Capital and Income 

We have now learned what capital and income are and 
how each is measured. We have seen that the term '' capi- 
tal " is not to be confined to any particular part or kind of 
wealth, but that it appKes to any or all wealth existing at a 
given instant of time, or to property rights in that wealth, 
or to the values of that wealth or of those property rights. 
We have seen that income is not restricted to money-in- 
come, but that it consists simply of the benefits of wealth. 
We have seen that, like capital, income may be measured 
either by the mere quantity of the various benefits or by the 
value of those benefits. We have seen that in the addition 
both of capital-value and of income-value there are two 
methods available for cancehng positive and negative items, 
called respectively the " method of balances " and the 
" method of couples." By the method of balances the nega- 
tive items in any individual account are deducted from the 
positive items in the same account, and the difference or 
'' balance " gives the net capital (or income, as the case 
may be) with which that account deals, whether this net 
capital (or income) pertains to a particular owner or to a 
particular instrument. The method of couples, on the other 
hand, cancels items in pairs and is founded on the fact that,^ 
as to capital, every liability relation has a credit as well as 
a debit side, and that, as to income, every interaction is at 
once a benefit and a cost. 

We observed that the method of couples, fully carried 
out, reveals wherein capital and income ultimately consist. 

91 



92 ELEMENTS OF ECONOMIC SCIENCE 

This method, appKed to capital, gradually obliterates all 
partial rights, such as stocks and bonds, and exposes to 
view the concrete capital-wealth of a community. The 
same method appHed to income obliterates the " interac- 
tions " such as money payments between persons, and ex- 
poses to view an uncanceled outer fringe of benefits and 
costs. If the method is continued further, it leaves simply 
the final benefits of the wealth outside of ourselves poured, 
so to speak, into the human organism ; while, if the method 
be pushed to the utmost limits, so as to include this organ- 
ism itself within the accounts considered, it leaves simply the 
pleasant and unpleasant experiences of human consciousness, 
the satisfactions and the efforts of life. 

We have seen that capital and income are in many re- 
spects analogous, and are strictly correlative; that all 
capital yields income and that all income flows from capital 
— at least when the term " capital " is used in its broadest 
sense, which includes human beings. 

In spite of this close association between them, capital 
and income have thus far been considered separately. The 
question now arises : How can we pass from capital to in- 
come or from income to capital ? The bridge or link between 
them is the rate of interest. The rate of interest is the ratio 
between income and capital, both the income and the capital 
being expressed in money value. More specifically, the rate 
of interest is the ratio found by dividing the rate of flow of a 
uniform perpetual stream of income measured in terms of 
money hy the capital which such a stream is worth also measured 
in terms of money. Business men sometimes call the rate of 
interest the " price of capital " or the " price of ready 
money." Suppose, for instance, that any capital worth 
$10,000 to-day will secure a perpetual annual income worth 
$400 per year ; then the rate of interest is said to be 4 per 
cent. 

It will be observed that the preceding definition of inter- 
est involves the idea of perpetual income. Another defini- 



CAPITALIZING INCOME 93 

tion may be found without involving that idea. The rate 
of interest may be defined as the premium on money in 
hand at one date in terms of money to be in hand one year 
later. Present and future money never exchange at par. 
One hundred dollars to-day is always worth more than 
$ioo due one year hence. If, then, $ioo to-day will exchange 
for $104 one year hence, the premium — or rate of interest — 
is 4 per cent. That is, the price of to-day's money in next 
year's money is 4 per cent above par; for 104/ 100 exceeds 
100/ 100 by 4/ 100. 

We have, then, two definitions of the rate of interest, 
viz. " the price of capital in terms of income " and '' the 
premium on present money over money due one year 
hence." 

But the two definitions are quite consistent, and either 
may be converted into the other. The rates of interest in 
the two senses are, in fact, equal, unless one of them be sup- 
posed to change from year to year. For instance, if a man 
borrows $100 to-day and agrees to pay it back in one year 
with interest at 4 per cent, we may conceive of him as selling 
a perpetual income of $4 a year for $100 — that is, giving 
4 per cent interest in the " price " sense — and at the 
same time agreeing to buy it back for $100 at the end of 
one year. But these two stipulations — to sell and to buy 
back — amount simply to an exchange of $100 to-day for 
$104 next year — that is, an exchange at 4 per cent interest 
in the " premium " sense. Hereafter, therefore, we shall 
not attempt to distinguish between the two definitions of 
the rate of interest. 

By means of the rate of interest we can evidently trans- 
late, as it were, present money value into equivalent future 
money value, or future money value into its equivalent pres- 
ent money value. Thus, if we know that the rate of inter- 
est is 4 per cent, we can find how much $1000 to-day is worth 
next year or the year after and also how much $1000 due 
next year or the year after is worth to-day. To translate 



94 ELEMENTS OF ECONOMIC SCIENCE 

any present value into next year's value, we multiply by the 
factor 1.04; to translate any next year's value into this 
year's value, we divide by this factor 1.04. This operation 
is what we learned in our school arithmetics as " discount- 
ing." The rate of interest is thus a link between any two 
points of time — a hnk by means of which we may compare 
values at any different dates. 

The rate of interest, however defined, is a species of 
price, but a very different species from any prices mentioned 
in previous chapters. We have seen that the price of wheat 
enabled us to translate any given number of bushels of wheat 
into so many dollars' worth of wheat, and the prices of 
other goods, to translate, in like manner, their respective 
quantities into their money equivalents. Any price thus 
serves as a bridge or Hnk between the quantity of any good 
and its value. 

By means of prices we could convert a miscellaneous 
assortment of goods at any time into their money value 
for that same time or convert a miscellaneous assortment of 
benefits occurring through a period of time into their money 
value for that same period. By such prices we may only 
convert quantities into simultaneous money values. We 
cannot pass from one time to another. By means, how- 
ever, of that unique price called the rate of interest, we may 
convert the money values found for one time into their eqiu- 
valent at another time. The rate of interest is thus the 
hitherto missing link necessary for reckoning money equiva- 
lence universally. 

We are not yet ready to explain how the rate of interest 
comes about. In fact, we are not yet ready to explain how 
any prices come about. We must, for the present, take the 
rate of interest ready-made just as we have taken other 
prices ready-made. In the preceding chapters we have 
seen how to form capital accounts and income accounts by 
assuming the prices necessary in each case to turn quanti- 
ties into money values. We are now ready to show the rela- 



CAPITALIZING INCOME 95 

tions between these two sets of accounts by assuming a rate 
of interest to turn income into capital. It is worth while, 
however, at the outset to rid our minds of the idea that 
money is the one and only source of interest, just as we have 
already rid our minds of the idea that all wealth is money. 
We may, as we have seen, express a great many things in 
terms of money value which are not themselves money. 
This habit leads us unconsciously into the fallacy of thinking 
of these things as though they were actual money. If we 
question a man who says '' I have $10,000 of money invested, 
and from it I get $500 of money each year as interest," 
implying a rate of interest of 5 per cent, he will be forced to 
admit that he hasn't really got $10,000 of money at all, and 
perhaps even that the $500 of money interest which he says 
he gets each year is not at first in money form. He may then 
attempt to correct his statement by substituting the follow- 
ing : " I have put my $10,000 of money into a farm, and each 
year I get $500 by selling the crops." This form of state- 
ment brings to light two other things than money, viz. a 
farm and its crops. But even this form is in error, for it 
still seems to imply that there is somewhere some money 
($10,000) in the farm, and that this money in the farm yields 
some other money ($500) each year. The true form of 
statement is simply that the man has a farm which yields 
crops, and that both of these are worth, or their value may 
be measured in terms of, money, the farm being worth 
$10,000 and the crop $500. Money need not enter at all 
except as a matter of bookkeeping. Hence, if we are care- 
ful, we will avoid thinking and speaking of a fund of $10,000 
producing an interest of $500, but will instead think and 
speak of actual capital, such as farms, factories, railways, or 
ships worth $10,000 producing actual benefits (such as 
yielding crops, manufacturing cloth, or transporting goods) 
which benefits are worth $500. 

There is another confusion to be carefully avoided, viz. 
the confusion between interest and the rate of interest. If 



g6 ELEMENTS OF ECONOMIC SCIENCE 

the interest from $10,000 worth of capital is $500 worth of 
benefits, the interest is this $500 worth of benefits, but the 
rate of interest is 5 per cent. Interest and the rate of inter- 
est are as distinct as value and price and in the same way. 

The rate of interest, then, is a sort of universal time price 
representing the terms on which men consider this year's 
values exchangeable in next year's or future years' values. 
By assuming this rate, we are enabled to convert future 
values into present or present into future. 

§ 2. Capital as Discounted Income 

But although the rate of interest may be used either for 
computing from present to future values, or from future to 
present values, the latter process is far the more important 
of the two. Accountants, of course, are constantly comput- 
ing in both directions, for they have both sets of problems to 
deal with, but the problem of time valuation which nature 
sets us is that of translating the future into the present; 
that is, the problem of ascertaining the value of capital. 
The value of capital must be computed from the value of its 
expected future income. We cannot proceed in the opposite 
direction and derive the value of future income from the 
value of present capital. 

This statement may at first puzzle the student; for he 
may have thought of income as derived from capital. And 
this is true. Income in its original state is derived from 
capital in its original state. But the value of incom^e is not 
derived from the value oi capital. On the contrary, the value 
of the capital is derived from the value of the income. For 
not until we know how much income an item of capital will 
bring us can we set any valuation on that capital at all. 
The wheat crop depends on the land which yields it. But 
the value of the crop does not depend on the value of the 
land. On the contrary, the value of the land depends on 
the value of its crop. 



CAPITALIZING INCOME 97 

The present worth of anything is what men are wilhng 
to give for it. In order that each man may decide what he 
is wilHng to give, he must have two bits of data : (i) some 
idea of the value of the future benefits his purchase will 
bring him, and (2) some idea of the rate of interest by 
which these future values may be translated into present 
values. 

With these data he may derive the value of any capital 
from the value of its income by means of the connecting Hnk 
between them called the rate of interest. This derivation 
of capital- value from income- value is called " capitahzing," 
or, more generally, " discounting," income. 

§ 3. The Discount Curve 

Let us assume that the expected income is foreknown with 
certainty, and that the rate of interest is also known. With 
these provisos, when we know the income that will be yielded 
by any article of wealth or item of property, it is very easy, 
by the use of the rate of interest, to compute the capital- 
value of said wealth or property ; and this, whether the in- 
come accrues continuously or discontinuously ; whether it 
is uniform or fluctuating ; whether the installments of it are 
few or infinite in number. 

We begin by considering the simplest case, namely, that 
in which the future income consists of a single item accruing 
at a definite instant of time. If, for instance, one holds a 
property right by virtue of which he will receive at the end 
of one year a benefit worth $104, the present value of this 
right, if the rate of interest is 4 per cent, will be $100. Or if, 
by virtue of the property, he is to receive a benefit worth $1 
one year hence, its present value (interest being at 4 per 
cent) is found, as we have seen, by dividing the $1 by the 
factor 1.04. The result is $1 / 1.04 or $0,962 ; if the value to 
which the right entitles the owner is any other amount than 
$1, its present value is simply that other amount divided 



98 ELEMENTS OF ECONOMIC SCIENCE 

by 1.04. Thus the present value of I432 due in one year 
is $432/ 1.04, which is $415.38. 

Conversely, $1 to-day is the present value of $1.04 a 
year hence ; and $1.04 a year hence will then be the present 
value of $1,082 two years hence. This is by compound 
interest. The $1.04 due at the end of the first year, when 
multipKed by the factor 1.04, gives $1,082 as its equivalent 
at the end of the second year. The $1,082 is therefore the 
equivalent of, and is called the " amount " of $1 at the end 
of two years, just as $1.04 is the " amount " of $1 in one 
year. Thus $1 in the hand to-day is worth $1,082 in the 
bush two years hence and, since the same ratio appHes to all 
other sums, if we know the value of any sum two years hence, 
but not its present value, we may find the latter by simple 
proportion. Thus let $1 be the future value two years hence 
of a present unknown sum x. Then we have the following 
proportion : as this present sum x is to its future amount $1, 
so is the present sum $1 to its future amount $1 .082 . Solving 
the proportion, we find that x is $.924, which therefore is the 
present value of $1 due two years hence. The same prin- 
ciples apply to three or more years. 

We may illustrate this process by a diagram, much in the 
same way as geography is illustrated by a map. In Figure 2 
is a curve. A, A', A!\ P^" , etc. The latitudes of these points, 
or their vertical distances above the base fine, represent the 
values of capital as determined at given instants of time, 
and the longitudes or horizontal distances between them 
represent the intervals of time between those instants. 
Thus, let the point B represent the present instant, and let 
the longitude interval, BB' represent a year. Using the 
same intervals for successive years, we have AB representing 
any present capital, say $1, A'B' representing its equiva- 
lent next year, say $1.04, A^'B" ^ the equivalent two years 
hence, and so on. We see that A'B' is what we have called 
the " amount " of AB put out at interest for one year, and 
A'^B" is the '' amount " of the same, compounded for two 



CAPITALIZING INCOME 



99 



years. Conversely, AB represents the present value or 
discounted value of any one altitude on the curve, say 
A'B^, as well as of any other such as A''B'' or A'''B''\ 
The latitude of any point on the curve may thus be regarded 
either as the ^' amount " of the sum represented by any 
preceding latitude or as the " present value " of the sum 
represented by any succeeding latitude. Thus, if the total 
breadth of the diagram BB ^^^ is any length of time, say t 
years, we may either say that A^^^B^^^ is the future 



B* 



Fig. 2. 



B^*^ 



" amount " of the present ^^, or that the present ^^ is the 
"present value" of the future sum, A^*^B^^\ The line 



(t) 



A A not only ascends but at an accelerating rate — i.e. it 
does not ascend in a straight line, but gradually bends up- 
ward, forming a curve which in economics is called the 
'' discount curve." This curve, if prolonged to the left, 
will, of course, never reach the bottom line. It keeps 
becoming flatter and flatter so that its distance above the 
line can never become zero. 

Curves sometimes puzzle beginners, but they are very im- 
portant in economics, and make the subjects which they 
illustrate so clear and simple that the student should not 
fail to make himself master of their use at the outset. 



lOO ELEMENTS OE ECONOMIC SCIENCE 

The discount curve is a tool by which we can interpret 
the relations between income and capital. 

§ 4. Application to valuing Instruments and Property 

The principles which have been explained for obtaining 
the present value of a single future sum apply to many com- 
mercial transactions, such as to the valuation of bank assets, 
which exist largely in the form of " discount paper," or 
short-time loans of other kinds. The value of such a note 
is always the discounted value of the future payment to 
which it entitles the holder. Similarly, the value of any 
article of wealth, reckoned when that wealth is in course of 
construction, is the present value of what it will bring when 
completed, less the present value of the cost of completion. 
For instance, the maker of an automobile will, at any of its 
stages in the course of construction, appraise it as worth 
the discounted value of its probable price when finished and 
sold, less the discounted value of the costs of construction 
and selHng which still remain. The element of risk should 
not, of course, be overlooked ; but its consideration does not 
belong here. 

Another appKcation of these principles of capitalization 
is to goods in transit. A cargo leaving Sydney for Liver- 
pool is worth the discounted value of what it will fetch in 
Liverpool, less the discounted value of the cost of carrying 
it there. Other classical examples are wine, the value of 
which is the present worth of what it will be when " mellow " 
and ready for consumption; and young forests, which are 
worth the discounted value of the lumber they will ulti- 
mately form. 

Ordinarily, however, we have to deal not with one future 
sum but with a series of future sums. A man who buys a 
bond or a share of stock is really buying the right to a series 
of future items of income. But we can treat a series of 
items of income by discount curves in exactly the same way 



CAPITALIZING INCOME 



lOI 



that we can treat one such item. This fact is shown in 
Figure 3. Suppose that a represents the present point of 
time, and A the point of time in the future at which the last 
benefit occurs. The diagram refers to any instrument of 
capital, such as a house, or any property right, such as a 
bond. In either case the capital every season yields so many 
dollars' worth of benefits or income. This income is repre- 
sented by the short, heavy vertical hues drawn on the verti- 
cals. In the particular case here represented we have three 
stages. The capital yields about the same amount during 
each year of the first stage of four years. After that the 



N 



H 



Fig. 3. 

yearly income is greater during a second period of five years ; 
during the third and last period, of six years, it is still 
greater. The first period of income is represented by short, 
heavy vertical Knes drawn upward from the base ; the second 
by lines slightly longer, and the third by lines still longer. 
We thus have a series of fifteen heavy verticals represent- 
ing the successive item.s of income for fifteen years. Our 
problem is, on the basis of this series of fifteen lines repre- 
senting income, to construct a curve representing the value of 
the capital. This curve is AO, and must be constructed 
backward from ^ to 0. The value of this house or bond 
just before it is worn out or paid up is evidently about equal 



I02 ELEMENTS OE POLITICAL SCIENCE 

to the value of the income, then about to be had from the 
capital, represented by the last vertical, AB, to the right. 
A year earlier than this the capital will be worth the dis- 
counted value of ^5 as represented in the height /C of the 
discount curve (drawn backward one year from B). This 
is the value just after the item of income /;::t: has been detached. 
Its value just before fx was detached was, of course, greater 
by fx. This greater value is fD, the difference, CD, being 
equal to the benefit fx. Proceeding another year back, 
the value of the capital just after the income at that time is 
taken out, is eE, and just before that income is taken out, it is 
eF. In this way we may proceed backward year by year. 
Each tooth in this broken curve will have a height equal to 
the value of the benefits of the capital in the year at the be- 
ginning of which it stands. We thus construct a broken 
line or " curve," beginning at the farthest future point and 
working backward to the present. This curve represents 
the value of the capital at the various points of time prior 
to its wearing out. This curve goes up and down. It goes 
down suddenly, whenever a benefit is detached, and it goes 
up gradually, while remaining future benefits are anticipated 
and approaching. 

In this curve we have a picture of the history of the value 
of the capital it illustrates. We formed this curve backward. 
But now that it is formed, let us follow it forward. It be- 
gins with O, rises gradually until the first of its periodic 
benefits is reahzed, such as receiving a rent payment, a 
crop, or a coupon. When, let us say, a coupon is cut, the 
curve falls by the amount of that coupon. Each coupon 
cut off is represented by the heavy vertical line at the base ; 
the fall in the value of the capital, being exactly equal, is 
represented by the tooth immediately over said heavy 
vertical line. During the ensuing year the capital value 
gradually cKmbs up as the next coupon cutting approaches, 
when it again falls by the amount of that coupon ; and so on, 
always rising up in virtue of anticipation of future income 



CAPITALIZING INCOME IO3 

and falling after each realization. Finally, when the last 
coupon is taken out, the value of the capital vanishes alto- 
gether. The value of the capital fluctuates then, by a 
series of teeth. 

§ 5. Valuing a Bond 

Let us now apply these principles to the special case of 
valuing an ordinary bond, entithng the holder to a series 
of equal items of income and also to a larger single sum at 
the end. A so-called " 5 per cent, ten-year, $100 bond " 
means the right to receive an annuity of $5 a year for ten 
years, and in addition, $100 at the end of the ten years, 
called the '' principal." 

If the rate of interest is 5 per cent, and a man buys 
a bond which entitles him to an annual income of $5 a year 
for ten years and $100 returnable at the end of this period, it 
is evident that the purchase price of the bond must be $100 
or '' par." In this case the $5 of annual income is the 
interest on the purchase price, and the sum of $100 which is 
to be received at maturity is equal to the sum originally 
invested. Such a bond is called a 5 per cent bond, the an- 
nual installments of income are called '' interest," and the 
final payment of $100 is caUed '' principal." 

The value of a bond may, of course, be obtained by means 
of discount curves on precisely the same principles as were 
explained in relation to Figure 3. The only difference is in 
the size of the various installments of income represented 
by the original dark verticals from which the remainder 
of the diagram is derived.^ Figure 4 represents the value- 
history of a ten-year 5 per cent bond when the rate of in- 
terest is 5 per cent. 

We see that, at the beginning, the value of the bond is 
$100 or par (represented hy AB) ] and that it gradually in- 
creases in value to $105 {A^B^) at the end of the year, when 
it suddenly falls again to $100 {A'^B^) in consequence of 
the detachment of the first installment of $5. During the 



I04 



ELEMENTS OF POLITICAL SCIENCE 



next year it repeats the same cycle, and so on for each year 
until the ten years are up, when its value disappears to zero 
with the payment of the principal. 

But often the bond is not sold at par. If the bond is 
sold above par, say at $io8, the rate of interest realized by 
the investor is not 5 per cent at all, but only 4 per cent. 



'too 




100 



In this case the bond is only nominally a " 5 per cent bond." 
The true rate of interest is that rate of interest which, if 
used for discounting all the benefits — the 10 annual items 
of $5 each and the final item of $100 — will give the value 
at which the bond was actually bought, above or below par, 
as the case may be. Let this true rate of interest be 4 per 
cent. The 5 per cent bond is then said to be sold on a 4 



CAPITALIZING INCOME 



105 



per cent basis. The investor does not make 5 per cent, as 
he would, had he bought the bond at $100, but makes only 
4 per cent because he bought at $108. 

This capital- value ($108) of a so-called 5 per cent bond, 
sold or valued on a 4 per cent basis, is obtained by reckon- 



108 



noo 



'92i 




\5 J5 \5 |5 J5 [5 f5 JS 



100 



Fig. s. 

ing at 4 per cent the present values of the ten payments of 
$5 each and the present value of the final payment of $100, 
and adding these all together. 

In Figure 5 the upper Kne shows the value-history of the 
5 per cent bond sold on a 4 per cent basis, beginning with $108 
and, after the usual series of gradual rises and sudden falls, 
reaching par at the end of ten years and then dropping to 
zero. The difference between this curve and that in Figure 



I06 ELEMENTS OF ECONOMIC SCIENCE 

4 consists in the fact that the discount curves are all less 
steep in the upper curve of Figure 5 than the discount curves 
in Figure 4, and is due to the fact that the rate of interest is 
now supposed to be only 4 per cent instead of 5 per cent. If 
interest is 6 per cent, we shall have the lower of the two curves 
in Figure 5, made up of discount curves, steeper than those of 
Figure 4. This curve shows that the bond then begins at 
$93, reaching $100 or par in the ten years, and then drops to 
zero. 

It is worth noting that the final $105, although $100 of 
it is called " principal," is really just as truly income from 
the bond as all the items called " interest." The original 
investment is the real discounted value of all the expected 
receipts ; the final " returned " principal is simply a part of 
the largest of those receipts. The only difference between 
this receipt and the other smaller ones is that usually it 
is employed differently when received. It is usually " rein- 
vested," that is, exchanged for other long-time securities, 
whereas the smaller items of income, the so-called '' interest," 
are usually " spent," i.e. exchanged for articles of shorter 
duration, and thereby soon converted into true ^' final 
income " or satisfactions. The '' principal " and '' inter- 
est," therefore, while both are income with reference to the 
bond considered by itself, are apt to lead to different results 
when followed into the final transformations of purchase 
and sale which ensue. The principal, though income from 
the bond, is outgo for the new investment. The owner is 
thus virtually in possession of a perpetual series of payments 
of $5 a year. It is with a view to such an operation that the 
final payment of $100 on a bond is instinctively regarded as 
on a different footing from the other payments called " in- 
terest." It is called " principal," on the theory that it is 
to be reinvested in order to continue the perpetual income 
of $5. In theory, therefore, it represents capital, whereas 
the other payments represent only income. But we see now 
that both are income received from the bond as a source of 



CAPITALIZING INCOME 



107 



income, although either may, by reinvestment, be put into 
capital. That one of them is usually put back into capital, 
and the other not, is a matter of subsequent history, and 
does not affect the study of the present value of the bond 
itself. 

Elaborate tables have been constructed, called " bond- 
value books," calculated on the foregoing principles. They 
are used by brokers for indicating the true value of bonds 
on different bases. They are also used for solving the con- 
verse problem, viz. for finding the true rate of interest 
" realized " when a bond is bought at a given price. The 
following is an abridgment of these tables, for (so-called) 
3 per cent, 4 per cent, and 5 per cent bonds. The prices of 
the bonds in all cases are the prices immediately after an 
installment of income. 

Rates of Interest 

"Three Per Cent Bond" 









Years io Maturity 








Price 


















I 


2 


3 


5 


10 


20 


30 


so 


120 












1.8 


2.1 


2.3 


IIO 










1.9 


2.4 


2-5 


2.6 


105 






1-3 


2.0 


2.4 


2.7 


2.8 


2.8 


103 




1-5 


2.0 


2.4 


2.7 


2.8 


2.9 


2.9 


102 




2.0 


2-3 


2.6 


2.8 


2.9 


2.9 


2.9 


lOI 


2.0 


2-5 


2.7 


2.8 


2.9 


2.9 


2.9 


3-0 


100 


3-0 


3-0 


3-0 


3.0 


3-0 


3-0 


3-0 


3-0 


99 


4.0 


3-5 


3-4 


3-2 


3-1 


3-1 


3-1 


3-0 


98 


5-1 


4.1 


3-7 


3-4 


3-2 


3.1 


3-1 


3-1 


97 


6.1 


4.6 


4.1 


3-7 


3-4 


3-2 


3-2 


3-T 


95 


8.3 


5-7 


4.8 


4.1 


3-6 


Z-3 


3-3 


3-2 


90 




8.6 


6.7 


5-3 


4.2 


3-7 


3.6 


3-4 


80 








7-9 


5-7 


4-5 


4.2 


3-9 


70 










7-3 


5-5 


4.9 


4-5 



io8 



ELElilENTS OF ECONOMIC SCIENCE 



Rates of Interest 

"Four Per Cent Bond" 



Price 


Years to Maturity 


I 


2 


3 


5 


10 


20 


30 


so 


130 












2.2 


2.6 


2.9 


120 


• 








1.8 


2.7 


3-0 


3-2 


IIO 








1.9 


2.8 


3-3 


3-5 


3-6 


105 




1-5 


2-3 


2.9 


3-4 


3-7 


3-7 


3.8 


103 




2.5 


3-0 


3-3 


3.6 


3-8 


3.8 


3-9 


102 


2.0 


3-0 


3-3 


3-6 


3-8 


3-9 


3-9 


3-9 


lOI 


3-0 


3-5 


3-6 


3-8 


3-9 


3-9 


3-9 


4.0 


100 


4.0 


4.0 


4.0 


4.0 


4.0 


4.0 


4.0 


4.0 


99 


5-0 


4-5 


4.4 


4.2 


4.1. 


4.1 


4.1 


4.1 


98 


6.1 


5-1 


4-7 


4.5 


4-3 


4.2 


4.1 


4.1 


97 


7.2 


5-6 


5-1 


4.7 


4.4 


4.2 


4.2 


4.1 


95 


9.4 


6.7 


5.8 


5-2 


4.6 


4.4 


4-3 


4.2 


90 




9.6 


7.8 


6.4 


5-3 


4.8 


4.6 


4-5 


80 








9.1 


6.8 


5-7 


5.6 


5-1 



Rates of Interest 

"Five Per Cent Bond" 





Years to Maturity 


Price 




















I 


2 


3 


5 


10 


20 


30 


so 


140 












2.5 


3-0 


3-4 


130 










1-7 


3-0 


3-4 


3-7 


120 










2.7 


3.6 


3-9 


4.1 


IIO 






1.6 


2.8 


3.^ 


4.3 


4.4 


4-5 


105 




2.4 


3-2 


3-9 


4.4 


4.6 


4.7 


4-7 


103 


2.0 


3.4 


3-9 


4-3 


4.6 


4.8 


4.8 


4.8 


102 


3-0 


4.0 


4-3 


4.6 


4.8 


4.8 


4.9 


4.9 


lOI 


4.0 


4-5 


4.6 


4.8 


4.9 


4.9 


4.9 


5-0 


100 


5-0 


5.0 


5-0 


5-0 


5-0 


5-0 


5-0 


5-0 


99 


6.1 


5-5 


5-4 


5-2 


5-1 


5-1 


5-1 


5.1 


98 


7-1 


6.1 


5-7 


5.5 


5-3 


5-2 


5-1 


5-1 


97 


8.2 


6.6 


6.1 


5-7 


5-4 


5-2 


5-2 


5-2 


95 




7-7 


6.9 


6.2 


5-7 


5-4 


5-3 


5-3 


90 






8.9 


7.4 


6.4 


5-9 


5-7 


5-6 


80 










7.9 


6.9 


6.5 


6.3 



CAPITALIZING INCOME 109 



§ 6. Capital- value when Alternative Income Streams are 

Possible 

Thus far we have considered the possibihty of but one 
income stream from any given capital. But it often happens 
that, from the same instrument, there is a choice between 
several different income streams. Land may be used for 
grazing, agriculture, building, or recreation. Tools may be 
employed in a variety of ways, and the same is true of in- 
numerable articles of wealth, particularly when taken in 
combination. What, then, determines the value of the 
capital? It is obviously not the sum of the discounted 
values of the different income streams, but the discounted 
value of that one which is chosen in preference to all the 
others. What, then, determines the choice of the series of 
uses to which any given instrument may be put? Evi- 
dently that particular series of uses will be selected which 
yields the maximum present value. Thus, if land used for 
grazing purposes will yield a net service of $1000 a year 
forever, and interest is taken at 4 per cent, its value for 
grazing purposes is evidently $25,000. If, in like manner, 
the capital- value for some other use, say, for growing wheat, 
is $20,000, it is clear that the land will be employed for 
grazing rather than for growing wheat, and will derive its 
value from the grazing use and not from the wheat use. 

We conclude, therefore, that the value of any capital- 
good, either of wealth or of property rights, assuming that 
all future income is foreknown, is the discounted value of 
the income chosen. 

§ 7. Effect of changing the Rate of Interest 

If the rate of interest is changed, the value of all capital 
will be changed in the opposite direction. The amount of 
change, however, will be very different with different ar- 



no 



ELEMENTS OF ECONOMIC SCIENCE 



tides of capital. Thus, let us suppose five typica-1 articles 
as given in the following table : — 



Capital 



Net Income per Year 



Total 



Capital Value 
(Int. at 5 %) 



Capital Value 
(Int. at 2^ %) 



Land 
House 

Horse 
Suit of 

clothes 
Loaf of 

bread 



$1000 per yr. forever 
$1000 per yr. for 50 

yr 

$100 per yr. for 6 yr. 
$20 ist yr.; $10 2d 

yr 

$36.50 per yr., for i 
da}^ 



Infinite 

$50,000.00 
600.00 

30.00 



$20,000.00 

18,300.00 
508.00 

28.00 



$40,000.00 

28,400.00 
. 551-00 

29.00 



If the value of the benefits derivable from these various 
articles continues the same, but the rate of interest is 
suddenly cut down from 5 per cent to 2^ per cent, there will 
result a general increase in the capital- values, but a very 
different increase for difterent articles. The more enduring 
ones will be affected the most. These effects are seen in 
the last column of the table. When the rate of interest is 
halved, the value of the land will be doubled, rising from 
$20,000 to $40,000, but the value of the house will rise by 
only about 60 per cent, i.e. from $18,300 to $28,400; the 
value of the horse will rise only 10 per cent, i.e. from $508 to 
$551 ; the value of the suit will rise only from $28 to $29 ; 
and, finally, the value of the loaf of bread will not rise at 
all, but v^ll remain at 10 cents. We see in these five types 
of articles that the sensitiveness of capital-value to a 
change in the rate of interest is the greater, the more endur- 
ing the income. 



CHAPTER VII 

VARIATIONS OF INCOME IN RELATION TO CAPITAL 

§ I. Realized and Standard Income 

We have seen how the value of capital is derived from 
that of income. We have also seen that the value of capital 
rises in anticipation of income and falls with its reahzation, 
and that the alternate rise and fall may or may not be equal. 
If the income taken out is just equal to the appreciation of 
the capital, the capital is thereby restored to its original 
value. If more than this amount of income be taken 
out, the capital will be impaired; if less, the capital will 
accumulate. 

When the income taken out is such that the capital left 
is neither impaired nor increased, that income is called 
standard income, because it affords a convenient standard 
with which to compare other incomes. Thus, $50 a year is 
the standard income from capital worth $1000 when the rate 
of interest is 5 per cent; for, since such a capital will in- 
crease or appreciate $50 in the course of a year, and since 
just the amount of this appreciation is taken out, the capital 
wiU be left at the beginning of the next year at just the figure 
of the year before, |iooo. The standard income on any 
capital is the interest on that capital; that is, it is the in- 
come which will keep the capital value intact. 

But the owner of a capital of $1000 may take from it each 
year either more or less than the standard amount, $50. 
The $1000 merely means the present value, discounted at 
5 per cent, of some income stream ; but this income stream 
may take any one of an indefinite number of forms. It may 



112 ELEMENTS OF ECONOMIC SCIENCE 

take the standard form of a perpetual annual income of $50 
a year ; but it may also take the form of an income which is 
twice the standard, or $100 a year for 14 years, and which 
then ceases altogether ; for the discounted value of these 
14 sums is $1000. Or it may take the form of an income 
which is half the standard, or $25 a year for the first 10 
years, is then $167.50 a year for 10 years, and which then 
ceases ; for, discounted at 5 per cent, this income also will 
give a capital of $1000. 

There are, then, two kinds of income : first, the so-called 
standard income, just described ; second, " reaHzed " in- 
come. Realized income is whatever income is actually 
realized — that is, detached from the capital — in any given 
case. Standard income and realized income may, of course, 
sometimes be equal. 

Of all possible forms of income, then, we take the per- 
petuity as the standard and compare the others with it. For 
instance, the possessor of a property yielding $100 a year for 
14 years knows that he might sell this property for $1000 and 
reinvest in another property yielding the standard $50 a 
year forever. Contrasting this standard income of $50 a 
year forever which he might receive, with the income of 
$100 a year for 14 years which he does receive, he finds that 
his income exceeds the standard income, so long as it lasts, 
by $50 a year. This excess of $50 each year involves, how- 
ever, a reduction of $50 each year in the capital-value of 
his property. At the end of the first year the value of his 
property will be the discounted value of $100 a year for 
thirteen (instead of fourteen) years, which, if interest is still 
reckoned at 5 per cent, is $950. 

The principle is perfectly general, and may be summarized 
as follows : (i) When a property yields a specified foreknown 
income, and is valued by discounting that income according 
to a specified rate of interest, if the realized income is equal 
to the standard income, the value of the capital will remain 
at a uniform level. (2) If realized income exceeds standard 



VARIATIONS OF INCOME IN RELATION TO CAPITAL II3 

income, the value of the capital will be decreased by the 
amount of the excess. (3) If reahzed income is less than 
standard income, the value of the capital will be increased 
by the deficiency. 

Expressed in a single sentence, the general principle 
connecting realized and standard income is that they differ 
by the appreciation or depreciation of capital. It is thus 
possible to describe standard income as reahzed income 
less depreciation of capital, or else as realized income 
plus appreciation of capital. 

§ 2. Illustrations 

In order that these important relations may be as clear 
and vivid as possible, we shall illustrate them graphically, 
by concrete examples, and by business accounting. 

In Figure 3 we saw that the value of the capital at first 
increased each year, then remained stationary, and finally 
decreased. During the first period, therefore, the realized 
income was less than the standard income ; during the second 
period it was equal, and during the third greater. Let us 
look closely at a typical year in each period. During the 
first year the capital-value first ascended gradually from 
O to iV and then dropped suddenly to M. Its whole ascent, 
or the appreciation of the capital, was the difference in level 
of these two points or wN. Had this amount been de- 
tached at the end of the year, the capital would have been 
brought back to its original level and the income would have 
been standard. But the diagram shows that only NM was 
actually taken out. In other words, the realized income 
( NM) was less than the standard income ( Nw) by an amount 
{Mw) which represents the net increase, appreciation, or 
savings of capital- value. During the second year, likewise, 
less income is taken out than the year's total increase in 
capital- value, leaving a net increase of capital- value. After 
a few years, however, the situation changes. From L 



114 



ELEMENTS OF ECONOMIC SCIENCE 



the curve rises to K by an amount KJ, and the coupon 
cut out ( KJ) is in this case just equal to the appreciation ; 
that is, the realized income is equal to the standard income, 
and capital is restored to its value at the beginning of the 
year. In the third case the curve goes up from I to H, 
appreciating by the amount Hz, but the income HG taken 
out is in this case greater. The reaHzed income exceeds the 
standard, and capital is impaired by the difference {Gz) . 

To illustrate by concrete examples the distinction between 
standard and realized income, we use the following six 
typical cases. 



Capital 


Realized Income 
PER Year 


Capital 

Value 

(Int. at 5%) 


Standard 

Income 

FOR First 

Year 


Rate of 
Realized 

Value re- 
turn FtiiST 

Year 


Rate of 
Standard 
Value re- 
turn 


Forest land 

Farm land 

House 

Horse 

Suit of clothes 

Loaf of bread 


$1000 a yr. for 14 
yrs. and then 
$3000 a yr. for- 
ever .... 

$1000 per yr. for- 
ever .... 

$1000 per yr. for 
50 yrs. . . . 

$100 per yr. for 6 
yrs 

$20 ist yr. ; $10 
2d yr 

$36.50 per yr. for 
I day .... 


$40,000.00 

$20,000.00 

18,300.00 

508.00 

28.00 

.10 


$2000.00 

$1000.00 

915.00 

25.40 

1.40 

.00 


% 

2.5 
5 

5.4 

19.6 

71.4 

36,500 


% 

S 

5 
S 
5 
S 
5 



I. The forest land yields $1000 the first year on a capital- 
value of $40,000, from which, on the 5 per cent basis assumed, 
the standard income would be 5 per cent of $40,000 or $2000. 
Consequently, the realized income ($1000) is less than the 
standard income ($2000) by $1000. Therefore the forest 
will appreciate in the year by the excess, $2000 — $1000 or 
$1000, and will be worth $41,000 at the end of the year. It 
will continue to appreciate for 14 years, after which it will be 



VARIATIONS OF INCOME IN RELATION TO CAPITAL II 5 

worth $60,000, after which its realized income ($3000) will 
be equal to the standard income. 

2. The farm land yielding $1000 a year in perpetuity is 
worth $20,000, and continues to be worth that amount each 
succeeding year. The realized income of $1000 is always 
the standard income from $20,000. 

3. The house yields a reahzed income of $1000 on a capital- 
value the first year of only $18,300. The standard income 
from $18,300 would be only 5 per cent of 18,300 or $915. 
The consequence is an excess of realized over standard in- 
come of $1000 — $915 or $85, and a corresponding fall of 
$85 in the value of the capital. That is, the house depre- 
ciates by $85 in the year, or from $18,300 to $18,215. It will 
continue to depreciate each year until its value vanishes 
entirely at the end of 50 years. 

4. The horse also depreciates, and very fast. Its owner 
realized from the horse an income of $100 on a capital- value 
of $508, from which the standard income would be only 
$25.40. The difference between the reahzed and standard 
income is $100 — $25.40 or $74.60, and the horse will lose 
that much in value in the year. 

5. The suit of clothes yields an income the first year of 
$20 on a capital of $28, from which the standard income would 
be only $1.40. It therefore depreciates by the difference, 
$20—1.40 or $18.60. 

6. The loaf of bread yields for one day only at the rate of 
$3 6 . 50 a year or i o cents a day on a capital- value of i o cents, the 
standard income of which amounts to practically zero. 
Consequently, the loaf depreciates in a day by the difference 
between 10 cents and zero or 10 cents ; that is, loses its value 
entirely. 

In all cases the standard income is 5 per cent of the capital- 
value, while the reahzed income may be a higher or a lower 
percentage. Expressed in percentages, the actual rate of 
value return {i.e. ratio of reahzed income to capital) on the 
forest land is 2.5 per cent; on the farm land, 5 per cent; 



Il6 ELEMENTS OF ECONOMIC SCIENCE 

house, 5.4 per cent; horse, 19.6 per cent; clothes, 71.4 per 
cent; and bread, 36,500 per cent. The more rapidly the 
income is taken out the greater the rate of value return 
realized, but (if that rate exceeds the rate of interest) the 
more rapidly will the capital be exhausted. The house 
yields a rate but slightly higher than the rate of interest, 
and lasts 50 years ; the horse yields a rate nearly 4 times 
the rate of interest, but it lasts only 6 years; the clothes 
yield a rate over 14 times the rate of interest, but last only 
2 years, while the bread yields a rate almost inconceivably 
great, but lasts only a day. The farm land which yields a 
rate exactly equal to the rate of interest lasts forever, while 
the forest land, which yields a rate only half the rate of 
interest, not only lasts forever, but (so long as the reahzed 
rate of value return remains less than the rate of interest) 
also increases in value. 

The various cases supposed may also be illustrated by the 
dividends declared by a joint stock company. If a company 
declares dividends of 5 per cent (on the true value of its 
capital reckoned on a 5 per cent basis) , these dividends will 
be standard income of the capital because they will leave it 
intact. If the dividends are less than 5 per cent, capital will 
be accumulated ; i.e. a '^ surplus " will be added to the 
original capital. If the dividends are greater than 5 per 
cent, the capital or surplus previously accumulated will be 
decreased. In the last-named case the company is said to 
pay its dividends partly '' out of capital." Such a practice 
is unusual, and when it occurs is generally with intention to 
deceive as to the ability to pay dividends. It is, however, 
not always of such a character. Some land-selling companies 
in the West distribute dividends far above the standard, 
every one understanding that, by the nature of the business, 
the assets are to diminish with each sale. The same is 
true to some extent of mining companies. The dividends 
are big, but they are not supposed to keep on forever. 

A case at the opposite extreme occurs when the dividends 



VARIATIONS OF INCOME IN RELATION TO CAPITAL II7 

are made unusually small in order that the capital may be 
increased. There is in New York City a company which 
has never declared any dividends, but has been rolling up a 
large surplus for years, and whose stock is for this reason 
much above par. 

We have already seen that every item in an income 
account represents the income or outgo from some item in 
the capital account. That is, the income account consists 
merely in a statement of the income and outgo from each 
item of asset or liability, including that class of assets and 
liabilities which are alike claims and obligations, such as 
leases and employees' contracts. If the income for each 
item remains steady or standard, the relation between the 
capital and income accounts is very simple. In such a case 
(supposing the rate of interest to be 5 per cent) , eachitem in 
the capital account will constantly stand at twenty times the 
amount of the corresponding item in the income account. 

Rightly interpreted, the capital account merely represents 
as a whole the capitalization of expected items in the income 
account; and the fluctuations of the capital account corre- 
spond with the deviations from the standard income in the 
items of the income account. 

§ 3. Confusions to be Avoided 

With all the preceding explanations and illustrations the 
distinction between realized and standard income should 
be clear. Standard income is the income which ought to be- 
taken out in order to maintain capital intact, neither im- 
paired nor increased. Reahzed income is the income which 
really is taken out. The one income is only an ideal, the 
other, real. The realized is equal to the actual drop in the 
curve of Figure 3 ; the standard is what that drop would need 
to be in order to equal the previous gradual rise. 

Of these two concepts, realized income is by far the more 
fundamental. Everything else grows out of realized incomxe 



Il8 ELEMENTS OE ECONOMIC SCIENCE 

— the value of the capital and therefore the value of the 
interest upon that capital, which is the standard income, as 
we have seen. We cannot, as would at first seem possible, 
begin with capital- value and derive the actual income from 
it ; nor can we begin with standard income, for standard 
income presupposes some capital- value for which it is stand- 
ard. That is, standard income depends on capital- value, 
and capital-value depends on realized income. The order of 
dependence then is reahzed income, capital-value, standard 
income. All three of these concepts must be carefully 
distinguished. It is not uncommon to confuse them. The 
illustrative table will help to keep us from confusing them. 
For instance, from this table we see clearly one reason why 
certain articles have been erroneously identified with income. 
Bread has practically the same capital- value as income- value, 
so that, if a person were not accustomed to fine distinctions, 
he might think it unnecessary to discriminate between the 
lo cents which is the value of the use of the bread, and which 
is, therefore, income, and the lo cents which is the value of 
the bread itself, and which is, therefore, capital. There is 
almost as much danger of such confusion in the case of 
clothing; for there is only a slight difference between the 
$30 which is the value of the use of the suit, and is therefore 
income, and the $28 which is the value of the suit, and is 
therefore capital. As we pass to the more enduring articles, 
there emerges so wide a difference between the value of the 
use of an instrument and the value of the instrument itself, 
that there is no difficulty in distinguishing between them. 
But if the distinction is valid in one case, it is valid in the 
others. We find no difficulty in distinguishing between the 
shelter of a house, which is income, and the house itself, 
which is capital ; nor between their values. Thus the shel- 
ter is worth $1000 a year for 50 years (or $50,000 in all), 
whereas the house itself is the discounted value of all 
this $50,000, or $18,300. We should find no greater diffi- 
culty in distinguishing between the use of the clothes 



VARIATIONS OF INCOME IN RELATION TO CAPITAL II 9 

and the clothes nor between the use of the bread and the 
bread. 

The more rapidly any capital yields up its benefits, i.e. 
the greater the rate at which its realized income is taken out, 
the more the danger of confusing the capital with the income 
it yields. 

Again, the confusion between realized and standard income 
is fostered by the very effort of bookkeepers to make the two 
identical. To do so may be said to be the bookkeeper's ideal. 

We have shown the tendency to confuse three concepts, — 
standard income, realized income, and capital- value. We 
have also dealt with a fourth concept, which must not be 
confused with the other three, viz. savings. Savings in its 
broadest sense includes more than simply saved money. 
It includes all the net increase in capital- value after all in- 
come has been detached. It is the net appreciation or the 
difference {Mw in Figure 3) between the total appreciation 
of capital or standard income ( Nw) and the reahzed incom^e 
{M N). Savings are therefore still a part of capital. They 
are the part of capital saved from being taken out for income. 
They are not a part of reahzed income. The individual is 
always strugghng between saving more capital and realizing 
more income. He cannot do both, — have his cake and eat 
it too. A savings bank depositor is sometimes thought to 
draw income from his deposit when the interest merely 
"accumulates" in the bank. This is an error. The bank 
renders income when, and only when, money is drawn out 
of it. It occasions outgo when, and only when, money is 
put into it. If the depositor merely lets his deposit accu- 
mulate, he derives no income and suffers no outgo. There 
is no effect on income. The only effect is upon capital, 
which is made to increase. If we accept the fiction that 
the man who allows his savings to accumulate virtually 
receives the interest, we must, to be consistent, also accept 
the fiction that he redeposits it and so cancels the receipt. 
If the teller hands over the interest across the counter, the 



I20 ELEMENTS OF ECONOMIC SCIENCE 

depositor's account certainly yields up " income " to him, 
but if he hands it back, the account occasions " outgo, '' 
and the net result is simply a cancellation. This procedure 
reveals clearly the fact that the accumulation is not income. 

We have seen that net appreciation or savings are not 
income, but additions to capital. Likewise, net deprecia- 
tion or " wear and tear " are not outgo, but subtractions from 
capital. Almost every article except land ultimately de- 
preciates in value owing to the fact that the services left 
for it to render gradually diminish in number and value. 
The approaching cessation of services may be due to physi- 
cal wear, but not always. Sometimes the expression 
" wear and tear " is a misnomer. There are articles which 
suffer no physical change, but of which the services never- 
theless last only a limited period. On the Atlantic coast 
the fishermen sometimes construct temporary platforms 
which are pretty sure to disappear in the September gales. 
It is evident that without any physical deterioration the 
value of such property must nevertheless decrease rapidly 
as the end of the fishing season approaches. In like manner 
the " World's Fair " buildings at St. Louis depreciated, 
during the brief period of the fair, from $15,000,000, which 
was first paid for their construction, to $386,000, for which 
they were sold after they had served the purpose for which 
they were built. The buildings equipping a mine become 
worthless when the mine is exhausted. '' Wear and tear," 
therefore, is a phrase which we should use only in a meta- 
phorical sense. Even when there is actual physical dete- 
rioration, this deterioration acts upon the value only in so 
far as it decreases or terminates the flow of income, and not 
simply because of a physical change in the capital which 
bears the income. 

There are then four concepts which we must keep distinct, 
viz : — 

Realized income. 

Capital-value (the discounted value of expected reaHzed 
income) . 



VARIATIONS OF INCOME IN RELATION TO CAPITAL 121 

Standard income (the interest on capi tal- value) . 

Savings (the deficiency of reahzed compared with standard 
income) ; and its opposite, " wear and tear " (the excess of 
reahzed compared with standard income). 

These are given in the order of dependence on reahzed 
income. 

§ 4. Standardizing Income 

Various devices have been made to make reahzed income 
standard, or, as we may express it, to standardize income. 
The method of the depreciation fund has aheady been men- 
tioned under income accounts. By it, an irregular income 
is converted into a regular income ; and we know that the 
capital-value of a perpetually regular income will remain 
constant. For instance, the possessor of $18,300 purchases 
a house and obtains at first an incom^e worth $1000 a year. 
He knows, however, that by the end of 50 years the house 
will need to be rebuilt, and therefore sets aside a depreciation 
fund into which he pays annually a sum equal to the depre- 
ciation of his house. This, in the first year, is $85, as we have 
seen. At the end of 50 years his depreciation fund is large 
enough to rebuild the house. Although the house hy itself 
does not yield him a standard income ($915), but $1000 a 
year for 50 years, yet the house and the depreciation fund 
taken together yield him the standard $915 in perpetuity, 
or as long as he keeps up the system. 

In this way, any instrument may be made to yield a 
standard income, not by itself, but conjointly with a depre- 
ciation fund. The latter is often forgotten. Only by ac- 
tually paying into this fund can realized income be stand- 
ardized. Merely to reckon what the depreciation is will 
not make the income standard. Reckoning depreciation is 
as poor a substitute for providing a fund to meet deprecia- 
tion as Beau Brummel's keeping a dinner hour was a sub- 
stitute for a dinner. Of course, depreciation payments 
only standardize or change the time-shape of one man's 



122 ELEMENTS OP ECONOMIC SCIENCE 

income at the expense of some other man's income. That 
is, every addition and subtraction caused in the one man's 
income implies equal and opposite changes in some other 
man's. A banker must be found who is willing to take the 
$85 and succeeding payments and pay back $18,300 at 
the end of 50 years. 

To society as a whole such purely shifting devices are 
inapplicable, for society can find no outside party on whom 
to shift the fluctuations. There is, however, a method by 
which society's income may be more or less standardized; 
namely, by assorting and combining the various instruments 
of capital wealth so that the various income streams may 
be mutually compensatory. For instance, suppose a com- 
munity owns an iron mine and a young forest. In the iron 
mine it has a form of property which for a time probably 
yields more than the standard income. Every bucketful of 
ore reduces the amount which the mine can yield in the future. 
After it is exhausted, there will be no further returns. The 
capital- value of the mine will therefore continue to depre- 
ciate. On the other hand, the forest land, which is covered 
with young saplings, will not begin to yield much income 
for many years. The income from this capital is therefore 
temporarily below the standard. A community which 
owns both mine and timber land will consequently find that 
the increase and decrease will tend to offset each other, so 
that its income will be more nearly standard than if it 
merely possessed either one without the other. 

The last-named method may sometimes be apphed even 
to a case of private enterprise ; for instance, in the case of 
capital which consists of a large number of instruments at 
different stages of production or consumption. If a weaving 
mill is equipped with 20 looms of the same degree of wear, the 
value of this plant will evidently diminish, and a deprecia- 
tion fund may be necessary. But if the 20 looms are evenly 
distributed throughout the different stages of wear, and if 
we assume that one loom wears out each year, no deprecia- 



VARIATIONS TO INCOME IN RELATION TO CAPITAL 1 23 

tion fund will be necessary. The replacement of one loom 
annually is equivalent to such a depreciation fund, and the 
capital is thereby maintained at a constant level. 

§ 5. The Risk Element 

There is one important feature in the relation between 
capital-value and income-value which has not yet been 
mentioned. This is the fact that at any point of time when 
we take accoxmt of capital- value, the future income from 
which it is discounted is only imperfectly foreknown. The 
capital- value is the discounted value of the future expected 
income, with all the risks of loss or chances of gain included 
in present expectations. 

Hitherto we have assumed that the entire future history 
of the capital in question is definitely known in advance ; 
in other words, we have ignored chance. The factory which 
was taken for illustration was supposed to yield definite 
future income which could be counted upon, precisely as 
interest on a bond may be counted on by the bondholder. 
But, as every enterprise ofi'ers chances both of gain and loss, 
we cannot close our discussion of capitalizing income with- 
out some account of how these chances affect the matter. 

It has been explained that capital-value increases with 
the approach of an anticipated installment of incom^e, and 
diminishes as that installment is reached and passed. These 
changes in capital- value take place when the future income 
is regarded as certain. The introduction of the element of 
chance will bring other and even more important changes in 
capital- value. If we take the history of the prices of stocks 
and bonds, we shall find it to consist chiefly of a record of 
changing estimates due to what is called chance, rather than 
of a record of the foreknown approach and detachment of 
income. Few, if any, future events are entirely free from 
uncertainty. In fact, property, by its very definition, is 
simply the right to the chance of future benefits. A mine 



124 ELEMENTS OF ECONOMIC SCIENCE 

owner takes his chances as to what the mine will yield ; the 
owner of an orange plantation in Florida takes his risk of 
winter frosts ; the owner of a farm assumes risks as to the 
effect of sun and rain and other meteorological conditions, 
as well as risks of the ravages of fire, insects, and pests 
generally. In buying an overcoat a man takes some risk 
as to its effectiveness in excluding cold, and as to the length 
of time it will continue to be serviceable. Even what are 
called " gilt-edged " securities are not entirely free from risk. 
Strictly speaking, therefore, every owner of property is a 
risk taker. 

§ 6. Five Methods of avoiding Risk 

Business men try not only to estimate the risks which they 
must encounter and to adjust their accounts accordingly, 
but they also endeavor to avoid these risks so far as possible, 
viz. : — 

{a) By increasing guaranties for the performance of 
contracts. 

(b) By increasing safeguards against incurring losses. 

(c) By increasing foresight and thereby diminishing the 
risks. 

(d) By insurance, that is, by consolidating risks. 

(e) By throwing risks into the hands of a special class 
of speculators. 

These will be considered in order. 

(a) The Method of Guaranties. In spite of the fact that 
the ownership of capital necessarily involves risk, since the 
income from it can only be estimated, never precisely fore- 
known, it is nevertheless possible, by a division of the 
ownership of capital-wealth, for one class of property 
holders to assume the burden of risks and to guarantee to 
another class a fixed income. This is the primary reason 
for the separation of securities into two great classes, called 
stocks and bonds. In any large enterprise the stockholders 
take the risks, and by so doing guarantee to the bondholders 



VARIATIONS TO INCOME IN RELATION TO CAPITAL 1 25 

a fixed income. As was remarked in a previous chapter, 
the capital stock acts as a buffer between the HabiHties and 
the assets, which amounts to saying that it guarantees a 
fixed income to the holders of the various liabilities. Presi- 
dent Hadley has emphasized the fact that a bondholder 
^' commutes " the precarious income of an enterprise into a 
fix:ed annuity, and that the system by which one class re- 
ceives " interest " and another " profits " has its origin in 
the desire of one class to avoid, and the willingness of another 
to assume, risks. 

(b) The Method of Safeguards. The method of guaran- 
ties is really a method of shifting risks rather than of avoiding 
them. The second method — that of safeguards — aims 
to reduce the risk. Some safeguards are themselves articles 
of wealth existing simply for the sake of meeting sudden 
unforeseen emergencies. This is true, for instance, of fire 
engines, fire extinguishers, safety valves, safety appliances 
on railways, burglar alarms, safety deposit vaults, etc. 
To a large extent this risk-meeting function applies to almost 
every stock or store of wealth. Food in a pantry usually 
exists beyond certain wants in order to provide for uncertdln 
wants, and when sources of supply are distant, such stores 
of food need to be large. Especially is this true in the case 
of armies. Again, a factory will usually have a large reserve 
stock, both of raw materials and finished products, in order 
to meet unexpected demands. In like manner, jobbers, 
wholesalers, and retailers maintain a sufficient stock of goods 
to meet not only the foreseen, but some of the unforeseen 
demands of their customers. The function of speculators 
in grain or other commodities consists largely in conserving 
the stock of a community as a safeguard against future 
scarcity. Almost all of what is called the reserve of a bank 
is used as a safety fund to meet the unforeseen demands of 
note holders and depositors, and, in particular, to meet a 
^' run " on the bank. These reserves often remain as idle 
as a fire extinguisher for years or even decades. It is said 



126 ELEMENTS OF ECONOMIC SCIENCE 

that there are bars of precious metals in the Bank of Eng- 
land which have lain there undisturbed for two centuries. 
A large part of the cash carried by an ordinary individual is 
quite analogous to a bank reserve, being held to meet special 
emergencies. Some individuals even keep in a separate 
pocket a special gold piece, lest some day they should be- 
come '' stranded." It may be said that this risk-meeting 
function of pocket cash is the chief compensation for the 
so-called " loss of interest " on the money thus carried. 
The convenience and security obtained by having an ade- 
quate supply is a species of income replacing the income 
which might be earned were the sum invested. 

{c) The Method of increasing Knowledge. The third 
method of reducing risks is by increasing knowledge. Risk 
is nothing but an expression of ignorance, and decreases with 
the progress of knowledge. It may be said that the chief 
progress now being made industrially consists in lifting the 
veil which hides the future. Countless trade journals 
have their main reason for existence in enabling their readers 
better to forecast the future, by supplying them with data 
as to past and present conditions, as well as by instructing 
them in the relations of cause and effect. Government 
reports of crops, technical schools, and agricultural colleges, 
all tend in the same direction. Whereas formerly the mine 
prospector could only guess wildly at the ore '' in sight " 
and the time and cost required to mine it, the graduate of a 
mining school is now able, through knowledge of geology 
and metallurgy, to bring these forecasts into some degree 
of scientific accuracy. And whereas until recently farming 
was one of the most uncertain of occupations, it is to-day — 
thanks to modern scientific agriculture — almost if not 
quite as amenable to prediction as industry or commerce. 

{d) The Method of Insurance. We come now to that im- 
portant means of avoiding and shifting risks called insurance. 
Insurance involves the offsetting of one risk by another; 
that is, the consolidation in an insurance company of a 



VARIATIONS TO INCOME IN RELATION TO CAPITAL 1 27 

large number of chances whereby relative certainty is, as it 
were, manufactured out of uncertainty. 

One effect of insurance on the individual is to steady the 
income from his property. The owner of a house would 
receive, if it were not insured, let us say, a net annual in- 
come, after providing for depreciation, of 5 per cent on 
$10,000, or $500 a year until the house was burned, after 
which he would receive nothing ; whereas, if he insures, he 
receives this S500 income less his premium up to the date of 
the fire, and afterward the income from the indemnity paid 
him by the company. 

The same principles apply to other forms of insurance, — 
such as marine insurance, which, by consolidating in an 
insurance company the risk on a large number of vessels, 
reduces for the individual even the perils of the sea to rela- 
tive certainty and regularity; or steam boiler insurance, 
which in a similar manner treats the risks of explosion; 
or plate-glass insurance, burglar insurance, live stock in- 
surance, hail and cyclone insurance, fidelity insurance, acci- 
dent insurance, employer's liability insurance, and, above 
all, life insurance. The last-named form of insurance, like 
the others, tends to steady the income of the beneficiary. 
If a wife holds insurance on her husband's life, the conse- 
quence is that, although what he gives her during his life is 
somewhat diminished, her income will not suddenly cease 
at his death. The tendency of insurance here, as elsewhere, 
is to make regularity out of irregularity, relative certainty 
out of relative uncertainty; and where, under the form of 
insurance contracts, the opposite result follows, the case is 
not one of true insurance, but tends to become one of 
gambUng. Thus, if a person insures the Hfe of some one 
in whom he has no financial interest, he is merely gambling 
on that person's life. Some years ago in Michigan there 
was an abuse of this type, called " graveyard insurance." 
Speculators went through the form of insuring the lives of 
certain old persons, — in other words, of betting on their 



128 ELEMENTS OF ECONOMIC SCIENCE 

deaths, a procedure not only vicious as gambling, but calcu- 
lated also to lead to crime. The same considerations apply to 
fire insurance, where a person insures a building in which he is 
not financially interested, or over insures one in which he is. 

(e) Shifting Risks to Speculators. Dangers of Imitative 
Speculation. Where risks cannot be reduced to a statistical 
basis, and therefore cannot be insured against, recourse is 
often had to the shifting of the risks into the hands of those 
who are wiUing to take them. Such persons are called 
speculators. A speculator is usually one in whom caution is 
not so pronounced as in the ordinary individual. In ex- 
treme cases he tends to become a simple gambler. The 
distinction between a speculator and a gambler, however, is 
usually fairly well marked. A gambler seeks and makes 
risks which it is not necessary to assume, whereas the specu- 
lator merely assumes those risks of business which must 
fall somewhere. A speculator is also usually fitted for his 
work by special knowledge, so that the risk to him, owing to 
superior foresight, is at the outset less than it would be to 
others. The common indiscriminate prejudice against all 
speculation is unjust and unfortunate; for, were there no 
speculators, the same risks would have to be borne by those 
less fitted to bear them. The chief evils of speculation flow 
from the participation of the general public, which lacks the 
special knowledge, and which enters the market in a purely 
gambling spirit. In addition to suffering the usual evil 
consequences of gambling, they produce evil consequences 
for the non-participating public by increasing instead of 
decreasing the fluctuations in the values of the products or 
property in which they speculate. 

The evils of speculation are particularly acute when, as 
generally happens with the investing public, the forecasts 
are not made independently. Were it true that each 
individual speculator made up his mJnd without consultation 
with others as to the future course of events, the errors of 
some would probably be offset by those of others. But, as a 



VARIATIONS TO INCOME IN RELATION TO CAPITAL 1 29 

matter of fact, the mistakes of the common herd are usually 
in the same direction. Like sheep, they tend to follow the 
same leader. We see, then, that where speculation is imita- 
ti/e, it is in the end injurious — alike to those who engage in it 
and to the pubHc which pays or receives the artificial prices 
thus created. Where, on the other hand, speculation is based 
on independent knowledge, it is usually of great utility. It 
operates both to reduce risk by means of utilizing the special 
knowledge of speculators, and also to shift risk from those who 
lack this knowledge to those who possess it. The normal 
consequence is that speculative property will gravitate into 
the hands of those most able to forecast its true income. 

Modern production has been called capitaHstic specula- 
tive production, owing to the fact that it is managed by 
" captains of industry," who are specially fitted at once to 
forecast and to mold the future within the special realms 
in which they operate. The industries of transportation 
and manufacturing particularly are under the lead of an 
educated and trained speculative class, whose function it is 
to assume for themselves the main risks, and leave the ordi- 
nary investor, who is not so equipped, to cooperate as a 
mere " lender " or silent partner. Yet it often happens 
that these '' captains '^ betray the confidence placed in them, 
and continue to throw the burden of risk on those whom they 
pretend to shield. 

§ 6. Review 

The preceding chapters are intended to give a definite 
picture of the mass of capital and its benefits to man. In 
such a picture we see man standing in the midst of a physical 
universe ; the events of this universe affect his Hf e favorably 
or unfavorably. Over many of these events he can exercise 
no control or selection ; they constitute his natural environ- 
ment. Over others he exercises selection and control by 
assuming dominion over part of the physical universe and 
fashioning it to suit his own needs. The parts of the material 



130 ELEMENTS OF ECONOMIC SCIENCE 

world which he thus appropriates constitute wealth, whether 
they remain in their natural state or are ''worked up'' 
by him into products to render them more suitable to his 
needs. This mass of instruments will consist, first, of tlr.e 
appropriated parts of the surface of the earth, of the build- 
ings and structures attached to the soil, and of the movable 
objects or " commodities " which man possesses and stores 
up; and secondly, of the human beings themselves, for 
these, though they are also the abode of the owners of 
wealth, are themselves owned objects. 

This mass of instruments serves mean's purpose in so fars a 
its possession enables him to modify the stream of occur- 
rences. By means of land and the m^odifications to which he 
subjects it he is enabled to increase and improve the growth 
of the vegetable and animal kingdoms in such a way as to 
supply him with food and the materials for constructing 
other instruments. By means of dwellings and other build- 
ings he is enabled to avert or minimize the unfavorable 
effects of the elements upon his body and upon the articles 
of wealth which he stores in those buildings. By means of 
machinery, tools, and other instruments of production, he is 
enabled to fashion new instruments, to add to his store of 
goods or to supply the place of those destroyed or worn out. 
By means of the final finished products which minister to 
his more immediate enjoyments — such, for instance, as food, 
clothing, books, ornaments — he is enabled to consummate 
the objects for which the entire mass of wealth is produced 
and kept in existence, namely, the satisfaction of his desires, 
whether these be for the necessities, the comforts, the lux- 
uries, or the amusements of fife. In these and other ways 
the stock of wealth will modify the course of natural events 
in ways more or less agreeable to the owner. These desir- 
able changes in the stream of events which occur by means of 
wealth constitute the benefits of wealth. But these benefits 
are obtained by dint of certain costs. In the last analysis 
costs are simply human efforts, and benefits are simply human 



VARIATIONS TO INCOME IN RELATION TO CAPITAL 131 

satisfactions ; but the interval between efforts and satisfac- 
tions is divided into so many stages, and at each of these 
stages there are so many processes of production or exchange 
that these intermediate occurrences, or interactions, are 
much more in evidence than either the efforts which precede 
them or the satisfactions which follow. Each interaction is 
accounted as a benefit in one aspect and a cost in another. 
Their values are, at bottom, merely the discounted values of 
the future benefits (less costs) to which they lead. 

The whole economic structure therefore — all that is 
represented in capital and income accounts — rests on two 
ultimate elements, viz. efforts and satisfactions. These enter 
our accounts, transformed simply by being multiplied or 
divided by prices, including that important price called the 
rate of interest. By means of such price factors we reach 
from these elements first the interactions which depend 
on them, then the complete income and outgo accounts 
(containing the values of interactions, efforts, and satis- 
factions) , and then the capital accounts (containing the dis- 
counted values of the items in the income accounts) . 

To recapitulate in a few words the nature of capital and 
income, we may say that those parts of the material universe 
which at any time are under the dominion of man, constitute 
his capital-wealth; its ownership, his capital-property; its 
value, his capital- value. Capital implies anticipated in- 
come, which consists of a stream of benefits or its value. 
When values are considered, the causal relation is not from 
capital to income, but from income to capital; not from 
present to future, but from future to present. In other 
words, the value of capital is the discounted value of the 
expected income. The fluctuations of this capital-value 
will, chance aside, be equal and opposite to the divergencies 
of " realized income " from " standard income " ; whereas, 
when the influence of chance is included, there will be in 
addition to these fluctuations still others which mirror the 
successive chancres in the outlook for future income. 



CHAPTER VIII 

THE EQUATION OF EXCHANGE 

§ I. Introductory 

We have now finished the first great division of our sub- 
ject, — Economic Accounting. We have gained a picture of 
wealth, property, benefits, costs, capital, and income. Our 
study has so far consisted in pointing out the fundamental 
relations between these various concepts, and particularly 
between capital and income. 

All of these relations find expression through the medium 
of prices. By prices, as we have seen, a miscellaneous col- 
lection of goods may be translated into a homogeneous mass 
of money values. Only by such reduction to a common 
money basis are capital and income accounts possible. 
Capital accounts and income accounts are mosaics of hetero- 
geneous elements fitted together by prices. But in all the 
capital and income accounts to which reference has thus far 
been made, and in all our previous discussions, we have 
taken prices for granted. We have, in other words, started 
out in our investigations upon the assumption that prices 
were fixed and known. But inasmuch as prices themselves 
are the outcome of economic forces, they must in turn be 
made the subject of analysis, and we must consequently now 
take up the second part of our task, which consists in dis- 
covering the principles that determine prices. 

If one were to ask how the price of wheat is determined, 
the immediate answer would probably be : By supply and 
demand. This answer, though correct so far as it goes, is 
lamentably superficial. It is well to be on one's guard 
against glib phrases which are so often substituted for real 

132 



THE EQUATION OF EXCHANGE I33 

analyses : '' Supply and demand" is such a phrase. A long 
time ago, when economics consisted rather of glib phrases 
than of real analyses, a critic of the science said, " If you 
want to make a first-class economist, catch a parrot and 
teach him to say ' supply and demand ' in response to every 
question you ask him. What determines wages ? Supply 
and demand. What determines interest? Supply and 
demand. What determines the distribution of wealth? 
Supply and demand." In every instance the answer is 
right, but it explains nothing. We must discover the forces 
which determine supply and demand. In so doing we shall 
learn that to determine the price even of one simple com- 
modity, like wheat, involves practically all the principles of 
economic science. We are not yet ready to undertake the 
full study of the supply and demand of any article. For the 
present we shall concern ourselves only with one of the im- 
portant forces underlying the supply and demand of all 
articles. That force is the purchasing power of money, a 
force as subtle as it is omnipresent. As every price is ex- 
pressed in money, it is evident that the willingness to take 
or give a certain amount of any article at a given price in 
money depends on the willingness to give or take a certain 
amount of money in exchange. This willingness to give or 
take money depends on the purchasing power of money over 
other things. Will a man pay 10 cents a pound for sugar? 
That depends on whether or not he wants the sugar more 
than something else purchasable with the 10 cents. The 
man, in other words, balances in his mind the sugar and the 
money, — the latter standing in his mind for any other thing 
he could spend it for. If the purchasing power of money is 
high, he will be more reluctant to part with a given amount 
for a given quantity of sugar than if it is low. The seller, on 
the other hand, is more ready to take money v/hen it has a 
high than when it has a low purchasing power. Hence, if in 
a given year money has a high purchasing power, the price of 
sugar will be lower than if money has a low purchasing power. 



134 ELEMENTS OF ECONOMIC SCIENCE 

The price of any particular article will be low if money has a 
high purchasing power ; that is, if the prices of articles in gen- 
eral are low. It is therefore clear that the money price of 
every particular commodity depends partly on the prices of 
other commodities, i.e. on the general level of prices, just as 
the actual height reached by a particular wave of the sea 
depends partly on the general level of the ocean. 

The phrases '^ the purchasing power of money " and " the 
general level of prices " are reciprocal. To say that the pur- 
chasing power of money is high or low is the same thing as to 
say that the general level of prices is low or high. If the 
first is doubled, the second is halved, and vice versa. 

It is possible to study the general level of prices independ- 
ently of particular prices, just as it is possible to study the 
general tides of the ocean independently of its particular 
waves. It is not only more logical to study the general price 
level first, but this order of study has also the advantage of 
acquainting us as early as possible with the nature of money. 

Therefore, before we attempt to explain even the demand 
and the supply of wheat, we shall undertake the study of 
prices in general. 

In practice, money is a most convenient device, but in 
theory it is always a stumbling block to the student of eco- 
nomics, who is exceedingly prone to misunderstand its func- 
tions. At the beginning of this book we pointed out some of 
the supposed functions of money that do not belong to it. We 
are now in a position to ask : What are the real functions of 
money ? 

§ 2. The Nature of Money 

We define money as what is generally acceptable in exchange 
for goods. The facility with which it may be thus exchanged, 
or its general acceptability, is its distinguishing characteris- 
tic. This general acceptability may be reenforced by law, 
the money thus becoming what is known as " legal tender " ; 
but such reenforcement is not essential. All that is necessary 



THE EQUATION OF EXCHANGE 135 

in order that any good may be money is that general accept- 
abihty attach to it. On the frontier, without any legal sanc- 
tion, money is sometimes gold dust or gold nuggets. In the 
colony of Virginia it was tobacco. Among the Indians in 
New England it was wampum. 

How does it happen that these things come into use as 
money ? If we consider, for instance, the tobacco money of 
the Virginia colony before metallic money came in from 
Europe, it is not difficult to see how (in all probability) it 
first became money. When a man in Virginia had a par- 
ticular commodity to sell, say a piece of land, and he looked 
about for a purchaser, he may have found a man who wanted 
that piece of land and sought to make a trade with him. He 
found this man willing, let us suppose, to take that piece of 
land in exchange for cattle, slaves, tobacco, jewelry, musical 
instruments, etc., or for collections of various articles, but he 
wanted none of these things. Under these circumstances, 
we may suppose the proposed purchaser of the land to have 
said, " I have a lot of tobacco, which I will give you for the 
land," and the landowner to have replied, " I do not smoke ; 
I do not want the tobacco." We may then suppose the 
purchaser to have said, " But tobacco is easily salable ; 
many people want it ; it is so easy to carry and to keep that 
you will find no difficulty in disposing of it ; will you not take 
it temporarily, and instead of smoking it yourself, find some- 
body to take it in trade." Whereupon the landowner sells 
his land for the tobacco — not in order to use it himself, but 
in order to sell it to some smoker. When, however, he sets 
about finding the smokers in the community, he may have 
some difficulty in disposing of his tobacco, just as did the pre- 
vious owner of the tobacco. But he can then follow the ex- 
ample of the previous owner, that is, find somebody who has 
the things that he wants, and whom he can induce to take 
the tobacco temporarily. In this way the tobacco may pass 
through many hands, in each of which it rests only tempor- 
arily before it is passed on. Gradually, in this manner, it 



136 ELEMENTS OF ECONOMIC SCIENCE 

becomes customary to take tobacco just for the purpose of 
passing it on, and not for the purpose of smoking it ; and 
after a time it is even prepared in a way not adapted to 
smoking, but convenient for passing on. At last everybody 
takes the tobacco simply because he expects others to take 
it ; everybody gets it only to get rid of it. It is then said to 
circulate as a medium of exchange. 

It was doubtless in some such way that gold came into 
use as money. Gold is easily transportable and durable. 
People who did not want it for ornaments took it to sell to 
people who did want it for ornaments, and after awhile 
it came to be coined for the purpose of being handed on. 
At first a number of different things were used for money ; 
but finally it was found that one thing was much more con- 
venient than the others, and it became the money par ex- 
cellence of the community. Tobacco acquired this function 
in Virginia ; gold possesses it to-day, having survived the 
competitive process by which a great many other kinds of 
money were tried out and found less suited to the purpose. 

There are various degrees of exchangeability which must 
be transcended before we arrive at real money. Of all forms 
of property, one of the least exchangeable is real estate. 
Only in case some person happens to be found who wants it 
can a piece of real estate be traded. A mortgage on real 
estate is one degree more exchangeable. Yet even a mort- 
gage is less exchangeable than a well-known and safe cor- 
poration security; and a corporation security is less ex- 
changeable than a government bond. In fact, persons not 
infrequently buy government bonds as merely temporary 
investments, intending to sell them again as soon as per- 
manent investments yielding better interest are obtainable. 
One degree more exchangeable than a government bond is a 
bill of exchange ; one degree more exchangeable than a bill 
of exchange is a sight draft ; while a check is almost as ex- 
changeable as money itself. Yet no one of these is really 
money, for none of them is ^^ generally acceptable." 



THE EQUATION OF EXCHANGE I37 

If we confine our attention to present and normal condi- 
tions, and to those means of exchange which either are money 
or most nearly approximate it, we shall find that money 
itself belongs to a general class of property rights which we 
may call " circulating media." A circulating medium in- 
cludes any type of property right which, whether generally 
acceptable or not, does actually, for its chief purpose and 
use, serve as a means of exchange. 

Circulating media are of two chief classes: (i) money; 
(2) bank deposits, which will be treated fully in the next 
chapter. By means of checks, bank deposits serve as a 
means of payment in exchange for other goods. A check is 
the " certificate " or evidence of the transfer of bank de- 
posits. It is acceptable to the payee only by his consent. 
It would not be generally accepted by strangers. Yet by 
checks, bank deposits, even more than money, do actually 
serve as a medium of exchange. 

But while a bank deposit (transferrable by check) is 
included in circulating media, it is not money. A bank 
note, on the other hand, is both circulating medium and 
money. Between these two hes the final line of distinc- 
tion between what is money and what is not. True, the 
fine is delicately drawn, especially when we come to such 
checks as cashier's checks or certified checks. For the 
latter are almost identical with bank notes. Each is a 
demand habihty on a bank, and each confers on the holder 
the right to draw money. Yet while a note is generally ac- 
ceptable in exchange, a check is only specially acceptable, 
i.e. only by the consent of the payee. Real money-rights 
are what a pa3^ee accepts without question, either because 
he is induced to do so by " legal tender " laws or because he 
is induced to do so by a well established custom. 

Of real money there are two kinds : primary and fiduci- 
ary. Money is called primary if it is a commodity which 
has just as much value in some use other than money as it 
has in monetary use. Primary money has its full value 



138 ELEMENTS OF ECONOMIC SCIENCE 

independently of any other wealth. Fiduciary money, on 
the other hand, is money the value of which depends partly 
or wholly on the confidence that the owner can exchange 
it for other goods, e.g. for primary money at a bank or gov- 
ernment office or at any rate for discharge of debts or pur- 
chase of goods of merchants. The chief example of primary 
money is gold coin. The chief example of fiduciary money 
is bank notes. The qualities of primary money which make 
for exchangeabihty are numerous. The most important are 
portabihty, durability, and divisibihty. The chief quahty 
of fiduciary money, which makes it exchangeable, is its re- 
deemability in primary money, or its imposed character of 
legal tender. 

Bank notes and all other fiduciary money, as well as bank 
deposits, circulate by certificates often called " tokens." 
" Token " coins are included in this description. The 
value of these tokens, apart from the rights they convey, is 
small. Thus the value of a silver dollar, as wealth, is only 
about forty cents ; that is all that the actual silver in it is 
worth. Its value as property, however, is one hundred 
cents ; for its holder has a legal right to use it in paying a 
debt to that amount, and a customary right to so use it in 
payment for goods. Likewise, the property value of a fifty- 
cent piece, a quarter, a ten-cent piece, a five-cent piece, or a 
one-cent piece is considerably greater than its value as 
wealth. The value of a paper dollar as wealth — for instance, 
a treasury note or silver certificate — is almost nothing. It 
is worth just its value as paper, and no more. But its value 
as property is a hundred cents, that is, the equivalent of 
one gold dollar. It represents to that extent a claim of 
the holder on the wealth of the community. 

Figure 6 indicates the classification of all circulating 
media in the United States. It shows that the total amount 
of circulating media is about 8j bilhons, of which about 7 
billions are bank deposits subject to check, and i J bilhons, 
money; and that of this ij bilhons of money i bilhon are 



THE EQUATION OF EXCHANGE 



139 



fiduciary money and only about J a billion primary 
money. 

In the present chapter we shall exclude the consideration 
of bank deposit or check circulation and confine our atten- 
tion to the circulation of money, primary and fiduciary. In 



Bank 

Deposits. 

SEVEN 


FmuciARY 
Money. 


BILLIONS. 


Primary 

MOMEX 

ONE-HALF 

BILU 


ONE 
BILU 



Fig. 6. 

the United States, the only primary money is gold coin. 
The fiduciary money includes (i) token coins, viz. silver 
dollars, fractional silver, and minor coins ('' nickels " and 
cents) ; (2) paper money, viz. : (a) certificates for gold and 
silver ; and (b) promissory notes, whether of the United 
States government ("greenbacks"), or of the national 
banks (" bank notes "). 



140 ELEMENTS OF ECONOMIC SCIENCE 

Checks aside, we may classify exchanges into three groups : 
the exchange of goods against goods, or barter ; the exchange 
of money against money, or ^' changing " money, and the 
exchange of money against goods, or purchase and sale. 
Only the last-named species of exchange makes up what we 
call the circulation of money. The circulation of money 
signifies, therefore, the aggregate amount of its transfers 
against goods. All money available for circulation, i.e. 
all money except what is in the banks' and United States 
government's vaults, is called money in circulation. 

§ 3. The Equation of Exchange, Arithmetically 
Expressed 

The price level may be said to depend on only three sets of 
causes : (i) the quantity of money in circulation ; (2) its 
" efficiency " or velocity of circulation (or the average 
number of times a year money is exchanged for goods) ; and 
(3) the volume of trade (or amount of goods bought by 
money). The " quantity theory " has often been incor- 
rectly formulated, but it is correct in the sense that the level 
of prices varies directly with the quantity of money in cir- 
culation, provided the velocity of circulation of that money 
and the volume of trade which it is obKged to perform are 
not changed. 

This will be made more clear by the equation of exchange, 
which is now to be explained. 

The equation of exchange is a statement, in mathematical 
form, of the total transactions effected in a certain period in 
a given community. It is obtained simply by adding to- 
gether the equations of exchange for all individual trans- 
actions. Suppose, for instance, that a person buys 10 pounds 
of sugar at 7 cents per pound. This is an exchange trans- 
action, in which 10 pounds of sugar have been regarded as 
equal to 70 cents, and this fact may be expressed thus : 
70 cents = 10 pounds of sugar multiplied by 7 cents a 



THE EQUATION OF EXCHANGE 141 

pound. Every other sale and purchase may be expressed 
similarly, and by adding them all together we get the equa- 
tion of exchange for a certain period in a given community. 
During this period, however, the same money may serve, 
and usually does serve, for several transactions. For that 
reason the money side of the equation does not represent 
the total amount of money in circulation. For instance, the 
same 70 cents may figure in 10 difi'erent transactions during 
the period under study, and thus perform the work, so to 
speak, of $7 used but once. The equation has a goods side 
and a money side. The money side is the total money paid, 
and may be considered as the product of the quantity of 
money multiphed by its rapidity of circulation. The goods 
side is made up of quantities of goods multiplied by their 
respective prices. 

Let us begin with the money side. If the number of dol- 
lars in a coimtry is 5,000,000, and the velocity of circulation 
is twenty times per year, then the total amount of money 
changing hands during any year is 5,000,000 times twenty 
or $100,000,000. 

Since the money side of the equation of exchange is 
$100,000,000, the goods side must be the same. For if 
$100,000,000 has been spent for goods in the course of the 
year, then $100,000,000 worth of goods must have been sold 
in that year. In order to avoid the necessity of writing 
out the quantities and prices of the innumerable varieties 
of goods which are actually exchanged, let us assume for 
the present that there are only three kinds of goods, — 
bread, coal, and cloth ; and that the sales are : — 

200,000,000 loaves of bread at $ .10 a loaf, 
10,000,000 tons of coal at 5.00 a ton, and 
30,000,000 yards of cloth at i.oo a yard. 

The value of these transactions is evidently $100,000,000, — 
i.e. $20,000,000 worth of bread plus $50,000,000 worth of 
coal plus $30,000,000 worth of cloth. The equation of ex- 



142 ELEMENTS OF ECONOMIC SCIENCE 

change therefore (remember that the money side consisted 
of $5,000,000 exchanged 20 times) is as follows : — 

$5,000,000X20 times a year = 

200,000,000 loaves X $ .10 a loaf + 
10,000,000 tons X 5.00 a ton + 
30,000,000 yards X i.oo a yard. 

This equation on the money side contains two magnitudes, 
viz. : (i) the quantity of money and (2) its velocity of circu- 
lation ; and, on the goods side, two groups of magnitudes in 
two columns, viz. : (i) the quantities of goods exchanged 
(loaves, tons, yards), and (2) the prices of these goods. The 
equation shows that these four sets of magnitudes are mutu- 
ally related. The prices, for instance, bear a relation to the 
three other sets of magnitudes, quantity of money, rapidity 
of circulation, and quantities of goods exchanged. Conse- 
quently these prices must, as a whole, vary proportionally 
with the quantity of money and with its velocity of circula- 
tion, and inversely with the quantities of goods exchanged. 
Suppose, for instance, that the quantity of money were 
doubled, while its velocity of circulation and the quantity of 
goods exchanged remained the same. Then it would be 
quite impossible for prices to remain unchanged. The 
money side would now be $10,000,000 X 20 times a year or 
$200,000,000; whereas, if prices should not change, the 
goods would remain $100,000,000 and the equation would 
be violated. Since exchanges, individually and collectively, 
always involve an equivalent quid pro quo, the two sides 
must be equal. Not only must purchases and sales be equal 
in amount, since every article bought by one person is nec- 
essarily sold by another, but the total value of goods sold 
must equal the total amount of money exchanged. There- 
fore, under the given conditions, prices must change in 
such a way as to raise the goods side from $100,000,000 to 
$200,000,000. This doubling may be accomplished by an 
even or uneven rise in prices, but some sort of a rise of prices 



THE EQUATION OF EXCHANGE 1 43 

there must he. If the prices rise evenly, they will evidently 
all be exactly doubled, so that the equation will read : — 

$10,000,000 X 20 times a year = 

200,000,000 loaves X $ .20 per loaf + 
10,000,000 tons X 10.00 per ton + 
30,000,000 yards X 2.00 per yard. 

If the prices rise unevenly, the doubling must evidently be 
brought about by compensation ; if some prices rise by 
less than double, others must rise by enough more than 
double to exactly compensate. 

But whether all prices increase uniformly, each being ex- 
actly doubled, or some prices increase more and some less 
(so as still to double the total money value of the goods pur- 
chased) the prices are doubled on the average. This proposi- 
tion is usually expressed by saying that the '' general level 
of prices " is raised twofold. From the mere fact, therefore, 
that the money spent for goods must equal the quantities of 
those goods multiplied by their prices, it follows that the level 
of prices must rise or fall according to changes in the quan- 
tity of money, unless there are changes in its velocity of 
circulation or in the quantities of goods exchanged. 

If changes in the quantity of money affect prices, so will 
changes in these other factors — quantity of goods and 
velocity of circulation — affect prices, and in a very similar 
manner. Thus a doubling in the velocity of circulation of 
money will double the level of prices, provided the quantity 
of money in circulation and the quantities of goods ex- 
changed for money remain as before. The equation will 
become — 

$5,000,000 X 40 times a year = 

200,000,000 loaves X $ .20 a loaf -|- 
10,000,000 tons X 10.00 a ton + 
30,000,000 yards X 2.00 a yard, 

or else the equation will assume a form in which some of the 



144 ELEMENTS OP ECONOMIC SCIENCE 

prices will more than double, and others less than double 
by enough to preserve the same total value of the sales. 

Again, a doubling in the quantities of goods exchanged 
will (not double but) halve the height of the price level, pro- 
vided the quantity of money and its velocity of circulation 
remain the same. Under these circumstances the equation 
will become : — 

$5,000,000 X 20 times a year = 

400,000,000 loaves X $ .05 a loaf + 
20,000,000 tons X 2.50 a ton +^ 
60,000,000 yards X .50 a yard, 

or else it will assume a form in which some of the prices are 
more than halved, and others less than halved, so as to pre- 
serve the equation. 

Finally, if there is a simultaneous change in two or all of 
the three influences, i.e. quantity of money, velocity of cir- 
culation, and quantities of goods exchanged, the price level 
will be a compound or resultant of these various influences. 
If, for example, the quantity of money is doubled, and its 
velocity of circulation is halved, while the quantity of goods 
exchanged remains constant, the price level will be undis- 
turbed. Likewise it will be undisturbed if the quantity of 
money is doubled and the quantity of goods is doubled, 
while the velocity of circulation remains the same. To dou- 
ble the quantity of money, therefore, is not always to double 
prices. We must distinctly recognize that the quantity of 
money is only one of three factors, all equally important as 
determinants of the price level. 

§ 4. The Equation of Exchange Mechanically Expressed 

The equation of exchange has now been expressed by an 
arithmetical illustration. It may be represented visually by 
a mechanical illustration. Such a representation is em- 
bodied in Figure 7. This represents a mechanical balance 



THE EQUATION OF EXCHANGE 1 45 

in equilibrium, the two sides of which symbolize respectively 
the money side and the goods side of the equation of ex- 
change. The weight at the left, symbolized by a purse, 
represents the money in circulation ; the ^' arm " or distance 
from the fulcrum at which this weight (purse) is hung repre- 
sents the efficiency of this money, or its velocity of circula- 
tion ; and the product of the weight by its " arm," ^ known 
in mechanics as the moment of rotation, represents the 
money side of the equation of exchange ; that is, the 
total circulation or value of exchange work done. In 





Fig. 7. 

accordance with the mechanical principles of a balance 
this is equal to, or balanced by, corresponding magnitudes 
on the opposite side. On that side are three weights : bread, 
coal, and cloth, symbolized respectively by a loaf, a coal 
scuttle, and a roll of cloth. The arm, or distance of each 
from the fulcrum, represents its price. In order that the 
lever arms at the right may not be inordinately long, we 
have found it convenient to reduce the unit of measure of 
coal from tons to hundredweights, and those of cloth from 
yards to feet, and consequently to enlarge correspondingly 
the numbers of units : the measure of coal changing from 
10,000,000 tons to 200,000,000 hundredweights, and that of 
the cloth from 30,000,000 yards to 90,000,000 feet. The 
price of coal in the new unit per hundredweight becomes 
25 cents, and that of cloth in feet becomes 33J cents. If, 
now, we assume that the velocity of circulation of money 
remains the same (that is, that the left arm does not either 

^ No necessary relation need exist between the units of length employed 
for measuring the arms to the right and those to the left. 



146 ELEMENTS OF ECONOMIC SCIENCE 

lengthen or shorten), and that the trade remains the same 
(that is, that the weights at the right do not either increase 
or decrease) , then it follows that the increase of the money 
at the left will require a lengthening of one or more of the 
arms at the right, representing prices, and that if these 
prices increase uniformly, they will increase in the same 
ratio as the increase in money ; and that, if they do not in- 
crease uniformly, some will increase more and some less than 
this ratio, maintaining an average. 

Likewise it is evident that if the velocity of circulation 
of money increases, i.e. if the arm at the left lengthens and if 




XI 




Fig. 8. 

the money in circulation and the trade (the various weights) 
remain the same, there must be an increase in prices (length- 
ening of the arms at the right). 

Again, if there is an increase in the volume of trade (rep- 
resented by an increase in weights at the right), and if the 
velocity of circulation of money (left arm) and the quantity 
of money (left weight) remain the same, there must be a 
decrease in prices (right arms) . 

Id general, any change in the four sets of magnitudes must 
be accompanied by such a change or changes in one or more 
of the other three as shall maintain equilibrium. 

As we are interested in the average change in prices rather 
than in the prices individually, we may simplify this me- 
chanical representation by hanging all the right-hand weights 
at one average point, so that the arm shall represent the 
average prices. This arm is a " weighted average " of the 



THE EQUATION OF EXCHANGE I47 

three original arms, the weights being literally the weights 
hanging at the right. 

This averaging of prices is represented in Figure 8, which 
visualizes the fact that the average price of goods (right 
arm) varies directly with the quantity of money (left weight) , 
and directly with its velocity of circulation (left arm), and 
inversely with the volume of trade (right weight). 

§ 5. The Equation of Exchange Algebraically Expressed 

To put these relations in general terms, we may use an 
algebraic formula : — 

MV = p Q 4- 

fQ' + 

etc. 

The quantity of money in circulation we call M, and the 
velocity of circulation, V. Then M V equals the amount of 
money expended for goods during the year. On the other 
side, p is the price of any good, and Q its quantity ; p' the 
price of another, and Q^ its quantity, and so on. If in this 
equation M is doubled (and V and the Q's remain un- 
changed), then the ^'s will, on the average, be doubled; if 
V is doubled, (and M and the g's are unchanged), the ^'s 
will be doubled also ; while if the Q's are doubled (and M 
and V are unchanged) , the ^'s will be halved. 

The right side of this equation is the sum of terms of 
the form pQ — a price multiplied by a quantity bought. 
It is customary in mathematics to abbreviate a sum of 
terms (all of which are of the same form) by using *' 2 " as 
a symbol of summation. This symbol does not signify a 
magnitude as do the symbols M, V, p, Q, etc. It signifies 
merely the operation of addition, and should be read '' the 
sum of terms of the following type." The equation of ex- 
change may now be written very simply : — 

MV = tpQ 



148 ELEMENTS OF ECONOMIC SCIENCE 

We may, if we wish, further simpHfy the right side in the 
form PT where P is a weighted average of all the ^'s, and 
T is the sum of all the Q's. P then represents in one magni- 
tude the level of prices, and T represents in one magnitude the 
volume of trade. This simplification is the algebraic inter- 
pretation of the mechanical illustration given in Figure 8, 
where all the goods, instead of being hung separately, as in 
Figure 7, were combined and hung at an average point repre- 
senting their average price. 

§ 6. The " Quantity Theory " of Money 

To recapitulate, we find then that, under the conditions 
assumed, the price level varies (i) directly as the quantity of 
money in circulation {M), (2) directly as the velocity of its 
circulation ( V) , (3) inversely as the volume of trade done by 
it (r). The first of these three relations is the most impor- 
tant. It constitutes the " quantity theory of money." 

So important is this principle, and so bitterly contested 
has it been, that we shall illustrate it further. By " the 
quantity of money " is meant the number of dollars (or other 
given monetary units) in circulation. This number may be 
changed in several ways, of which the following three are 
most important. They serve to bring home to us the con- 
clusions we have reached and to reveal the fundamental 
peculiarity of money on which they rest. 

As a first illustration, let us suppose the government to 
double the denominations of all money ; that is, let us suppose 
that what has been hitherto a half dollar is henceforth called 
a dollar, and that what has hitherto been a dollar is hence- 
forth called two dollars. Evidently the number of '' dol- 
lars " in circulation will then be doubled ; and the price 
level, measured in terms of the new '' dollars," will be 
double what it would otherwise be. Every one will pay out 
the same coins as though no such law were passed. But he 
will, in each case, be paying twice as many " dollars^ For 



THE EQUATION OE EXCHANGE 1 49 

example, if $3. formerly had to be paid for a pair of shoes, 
the price of this same pair of shoes will now become $6. 
Thus we see how the nominal quantity of money affects 
price levels. 

A second illustration is found in a debased currency. Sup- 
pose a government cuts each dollar in two, coining the halves 
into new *' dollars " ; and recalling all paper notes, replaces 
them with double the original number — two new notes for 
each old one of the same denomination. In short, suppose 
money not only to be renamed, as in the first illustration, 
but also reissued. Prices in the debased coinage will again 
be doubled just as in the first illustration. The subdivision 
and recoinage is an immaterial circumstance, unless it be 
carried so far as to make counting difficult and thus to inter- 
fere with the convenience of money. Wherever a dollar had 
been paid before debasement, two dollars — i.e. two of the 
old halves coined into two of the new dollars — will now be 
paid instead. 

In the first illustration, the increase in quantity was 
simply nominal, being brought about by renaming coins. 
In the second illustration, besides renaming, the further fact 
of recoining is introduced. In the first case the number of 
actual pieces of money of each land was unchanged, but their 
denominations were doubled. In the second case, the number 
of pieces is also doubled by splitting each coin and reminting 
it into two coins, each of the same nominal denomination as 
the original whole of which it is the half, and by similarly 
redoubling the paper money. 

For a third illustration, suppose that, instead of doubling 
the number of dollars by splitting them in two and recoining 
the halves, the government duplicates each piece of money 
in existence and presents the duplicate to the possessor of the 
original. We must in this case suppose, further, that there 
is some effectual bar to prevent the melting or exporting of 
money. Otherwise the quantity of money in circulation 
will not be doubled : much of the increase will escape. But 



150 ELEMENTS OF ECONOMIC SCIENCE 

if the quantity of money is doubled, prices will also be 
doubled just as truly as in the second illustration, in which 
there were exactly the same number of coins as now under 
consideration as well as the same denominations. The only 
difference between the second and the third illustrations 
will be in the size and weight of the coins. The weights of 
the individual coins, instead of being reduced, will remain 
unchanged ; but their number will be doubled. This doub- 
ling of coins must have the same effect as the 50 per cent 
debasement, i.e. the effect of doubling prices. 

The force of the third illustration becomes even more 
evident if, in accordance with Ricardo's presentation, we pass 
back by means of a seigniorage from the third illustration to 
the second. That is, after duplicating all money, let the 
government subtract half of each coin, thereby reducing the 
weight to that of the debased coinage in the second illustra- 
tion, and removing the only point of distinction between 
the two. This " seigniorage " abstracted will not affect the 
value of the coins, so long as their number remains un- 
changed. In short, the quantity theory asserts that (pro- 
vided velocity of circulation and volume of trade are un- 
changed) if we increase the number of dollars, whether by 
renaming coins, or by debasing coins, or by increasing coin- 
age, or by any other means, prices will be increased in the 
same proportion. It is the number, and not the weight, that 
is essential. This fact needs great emphasis. It is a fact 
which differentiates money from all other goods and explains 
the peculiar manner in which its purchasing power is re- 
lated to other goods. Sugar, for instance, has a specific 
desirability dependent on its quantity in pounds. Money 
has no such quality. The value of sugar depends on its 
actual quantity. If the quantity of sugar is changed from 
1,000,000 pounds to 1,000,000 hundredweight, it does not 
follow that a hundredweight will have the value previously 
possessed by a pound. But if money in circulation is 
changed from 1,000,000 units of one weight to 1,000,000 



THE EQUATION OF EXCHANGE 151 

units of another weight, the value of each unit will remain 
unchanged. 

The quantity theory of money thus rests, ultimately, on a 
pecuUarity which money alone of all goods possesses, — 
the fact that it has no power to satisfy human wants except 
a power to purchase things which do have such power. 



CHAPTER IX 

DEPOSIT CURRENCY 

§ I. The Mystery of Circulating Credit 

We are now ready to explain the nature of bank deposit 
currency, or circulating credit. Credit, in general, is the 
claim of a creditor against a debtor. Bank deposits subject 
to check are the claims of the creditors of a bank against the 
bank, by virtue of which they may, on demand, draw by 
check specified sums of money from the bank. Since no 
other kind of bank deposits v/ill be considered by us, we shall 
usually refer to '' bank deposits subject to check " simply as 
" bank deposits." They are also called " circulating credit." 
But as the first step we must enlarge upon our analysis of 
circulating media by adding a discussion of bank checks, by 
means of which credit is put into effect. Bank checks, then, 
are merely certificates of rights to draw bank deposits or 
to transfer them. The checks are not currency. It is the 
bank deposits themselves, or credit balances on the books of 
the banks, that constitute the real currency. Nor are these 
deposits actual money. They are not money, because they 
are not generally acceptable ; they always require the special 
consent of the payee. But they are currency, because their 
chief purpose and use is to act as a medium of exchange. . 
Closely analogous to checks are post office orders, and money 
orders issued by express companies. They are distinguish- 
able only by two facts : that they are not issued by ordinary 
banks, and that they originate in special deposits of money 
or the equivalent of money. For this reason, and because 
they are not of great importance, we prefer to place them in 
the same category with bank checks rather than to place 
them in a third class, which otherwise they might occupy. 

152 



DEPOSIT CURRENCY 1 53 

It is in connection with the transfer of bank deposits that 
there arises that so-called '^ mystery of banking " called 
circulating credit. Many persons, including some econo- 
mists, have supposed that credit is a special form of wealth 
which may be created out of whole cloth, as it were, by a 
bank. Others have maintained that credit has no founda- 
tion in actual wealth at all, but is a kind of unreal and in- 
flated bubble with a precarious if not wholly illegitimate 
existence. As a matter of fact, bank deposits are as easy to 
understand as bank notes, and what is said in this chapter of 
bank deposits may in substance be taken as true also of bank 
notes. The chief difference is a formal one, the notes cir- 
culating from hand to hand, while the deposit currency cir- 
culates only by means of special orders called checks. 

To understand the real nature of bank deposits, let us 
imagine a h3rpothetical institution, — a kind of primitive 
bank existing mainly for the sake of deposits and the safe 
keeping of actual money. The original bank of Amsterdam 
was somewhat like the bank we are now imagining. In such 
a bank a number of people deposit $100,000 in gold, each 
accepting a receipt for the amount of his deposit. If this 
bank should issue a '' capital account " or statement, it 
would show $100,000 in its vaults and $100,000 owed to 
depositors, as follows : — 

Assets ILiabilities 

Gold $100,000 Due depositors . . $100,000 

The right-hand side of the statement is, of course, made 
up of the amounts owed to individual depositors. Assum- 
ing that there is owed to A $10,000, to B $10,000, and to all 
others $So,ooo, we may write the bank statement as follows : — 

Assets Liabilities 

Gold $100,000 Due depositor A , . $ 10,000 

Due depositor B . . 10,000 

Due other depositors 80,000 

$100,000 $100,000 



154 ELEMENTS OF ECONOMIC SCIENCE 

Now assume that A wishes to pay B $1000. A could go to 
the bank with B, present certificates or checks for $1000, 
obtain the gold, and hand it over to B, who might then re- 
deposit it in the same bank, merely handing it back through 
the cashier's window and taking a new certificate in his own 
name. Instead, however, of both A and B visiting the bank 
and handling the money, A might simply give B a check 
for $1000. The transfer in either case would mean that 
A's holding in the bank was reduced from $10,000 to 
$9000, and that B's was increased from $10,000 to $11,000. 
The statement would then read : — 

Assets Liabilities 

Gold $100,000 Due depositor A . . $ 9,000 

Due depositor B . . 11,000 

Due other depositors . 80,000 

$100,000 $100,000 

Thus the certificates, or checks, would circulate in place of 
cash among the various depositors in the bank. What really 
changes ownership, or " circulates," in such cases is the right 
to draw money. The check is merely the evidence of this right 
and of the transfer of this right from one person to another. 

In the case under consideration, the bank would be con- 
ducted at a loss. It would be giving the time and labor of 
its clerical force for the accommodation of its depositors, 
without getting anything in return. But such a h3rpo- 
thetical bank would soon find — much as did the bank of 
Amsterdam — that it could '^ make money " by lending at 
interest some of the gold on deposit. This could not offend 
the depositors. These do not expect or desire to get back 
the identical gold they have deposited. What they want is 
simply to be able at any time to obtain the same amount of 
gold. Since, then, their arrangement with the bank calls for 
the payment not of any particular gold, but merely of a defi- 
nite amount, and that but occasionally, the bank finds 
itself free to lend out part of the gold that otherwise would 



DEPOSIT CURRENCY 1 55 

lie idle in its vaults. To keep it idle would be a great and 
needless waste of opportunity. 

Let us suppose, then, that the bank decides to loan out 
half its cash. This is usually done in exchange for promis- 
sory notes of the borrowers. Now a loan is really a sale, the 
quid pro quo being the promissory note which the lender — 
in this case the bank — receives in place of the gold. Let 
us suppose that so-called borrowers actually draw out 
$50,000 of gold. The bank thereby exchanges money for 
promises, and its books will then read : — 

Assets Liabilities 

Gold $ 50,000 Due depositor A . . $ 9,000 

Promissory notes . . 50,000 Due depositor B . . 11,000 

Due other depositors 80,000 

$100,000 $100,000 

It will be noted that now the gold in bank is only $50,000, 
while the total deposits are still $100,000. In other words, 
the depositors now have more " money on deposit " than 
the bank has in its vaults ! But, as will be shown, this 
form of expression involves a popular fallacy, in the word 
"money." Something good is on deposit behind each loan, 
but not necessarily money. 

Next, suppose that the borrowers become, in a sense, de- 
positors also, by redepositing the $50,000 of cash which they 
borrowed, in return for the right to draw out the same on 
demand. In other words, suppose that after borrowing 
$50,000 from the bank, they lend it back to the bank. The 
bank's assets will thus be enlarged by $50,000, and its 
obligations (or credit extended) will be equally enlarged; 
and the balance sheet will become : — 

Assets 

Gold $100,000 

Promissory notes . . 50,000 



Due depositor A . . 


$ 9,000 


Due depositor B . . 


11,000 


Due old depositors 


80,000 


Due new depositors, 




i.e. the borrowers . 


50,000 



$150,000 $150,000 



156 ELEMENTS OF ECONOMIC SCIENCE 

Now what happened in each case was this: Gold was 
borrowed in exchange for a promissory note and then handed 
back in exchange for a right to draw. Thus the gold really 
did not budge; but the bank received a promissory note 
and the depositor a right to draw. Evidently, therefore, 
the same result would have followed if each borrower had 
merely handed in his promissory note and received, in ex- 
change, a right to draw. As this operation most frequently 
puzzles the beginner in the study of banking, we repeat the 
tables representing the conditions before and after these 
" loans," i.e. these exchanges of promissory notes for present 
rights to draw. 

Before the Loans 

Assets Liabilities 

Gold $100,000 Due depositors . . $100,000 

After the Loans 

Gold $100,000 Due depositors . . $150,000 

Promissory notes . . 50,000 

Clearly, therefore, the intermediation of the money in 
this case is a needless complication, though it may help to a 
theoretical understanding of the resultant shifting of rights 
and liabihties. Thus the bank may receive deposits of gold 
or deposits of promises ; in exchange for the gold it gives a 
right to draw. In exchange for the promises it may give — 
or lend — either a right to draw, or gold — the same that 
was deposited by another customer. Even when the bor- 
rower has deposited only a promise, by fiction he is still held 
to have deposited money ; and like the original cash deposi- 
tors, he is given the right to make out checks. The total 
value of rights to draw, in whichever way arising, is termed 
deposits. Banks more often lend rights to draw (or deposit 
rights) than actual cash, partly because of the greater con- 
venience to borrowers, and partly because the banks wish 



DEPOSIT CURRENCY 1 57 

to keep their cash reserves large, in order to meet large or 
unexpected demands. It is true that if a bank loans money, 
part of the money so loaned will be redeposited by the per- 
sons to whom the borrowers pay it in the course of business ; 
but it will not necessarily be redeposited in the same bank. 
Hence the average banker prefers that the borrower should 
not withdraw actual cash. 

Besides lending deposit rights, banks may also lend their 
own notes — called " bank notes." And the principle 
governing bank notes is much the same as the principle 
governing deposit rights. The holder simply gets a pocket- 
ful of bank notes inkead of a bank account. In either case 
the bank must keep itself ready to pay the holder, — to '' re- 
deem its notes," — as well as pay its depositors, on demand, 
and in either case the bank exchanges a promise for a 
promise. In the case of the note, the bank has exchanged 
its bank note for a customer's promissory note. The bank 
note carries no interest, but is payable on demand. The 
customer's note bears interest, but is payable only at a defi- 
nite date. Assuming that the bank issues $50,000 of notes, 
the balance sheet will now become : — 

Assets Liabilities 

Cash $100,000 Due depositors . . $150,000 

Loans due the bank . 100,000 Due note holders . . 50,000 
$200,000 $200,000 

We repeat, then, that by means of credit, the deposits of 
a bank may exceed its cash. There would be nothing mysteri- 
ous or obscure about this fact, nor about credit in general, if 
people could be induced not to think of banking operations 
as money operations. To so represent them is metaphorical 
and misleading. They are no more money operations than 
they are real estate transactions. A bank depositor. A, has 
not ordinarily '' deposited money " ; and whether he has 
or not, he certainly cannot properly say that he '' has money 
in the bank." What he does have is the bank's promise 



158 ELEMENTS OE ECONOMIC SCIENCE 

to pay money on demand. The bank owes him money. 
When a private person owes money, the creditor never 
thinks of saying that he has it on deposit in the debtor's 
pocket. 

And yet, the same principles of property which apply to 
bank deposits also apply to bank notes. There is wealth 
somewhere behind the mutual promises, though in different 
degrees of accessibility. The note holder's promise is se- 
cured by his assets; and the bank's promise is secured by 
the bank's assets. The note holder has " swapped " less- 
known credit for better-known credit. The accounts as they 
now stand include the chief features of an ordinary modern 
bank, — a so-called "bank of deposit, issue, and discount." 

§ 2. The Basis of circulating Credit 

If this fact is borne in mind, the reader will be able to 
conquer the doubt which may already have arisen in his 
mind, — the doubt as to the legitimacy of the bank's pro- 
cedure in "lending some of its depositors' money." It 
cannot be too strongly emphasized that, in any balance 
sheet, the value of the Uabihties rests on that of the 
assets. The deposits of a bank are no exception. We 
must not be misled by the fact that the cash assets may 
be less than the deposits. When the uninitiated first learn 
that the number of dollars which note holders and depositors 
have the right to draw out of a bank exceeds the number of 
dollars in the bank, they are apt to jump to the conclusion 
that behind some of the notes or deposit-Habilities there is 
nothing. Yet behind all these obligations there is always, 
in the case of a solvent bank, full value ; if not actual dollars, 
at any rate dollars^ ivorth of property. By no jugglery can 
the Habilities exceed the assets except in insolvency, and 
even in that case only nominally, for the true value of the 
liabilities (" bad debts ") will only equal the true value of 
the assets behind them. 



DEPOSIT CURRENCY 1 59 

These assets, as already indicated, are largely the notes 
of merchants, although, so far as the theory of banking is 
concerned, they might be any property whatever. If they 
consisted in the ownership of real estate or other wealth in 
** fee simple," so that the tangible wealth which property 
always represents were clearly evident, all mystery would 
disappear. But the effect would not be different. Instead 
of taking grain, machines, or steel ingots on deposit, in ex- 
change for the money lent, banks prefer to take interest- 
bearing notes of corporations and individuals who own, 
directly or indirectly, grain, machines, and steel ingots ; and 
by the banking laws the banks are even compelled to take 
the notes instead of the ingots. The bank finds itself with 
liabilities which exceed its cash assets ; but in either case the 
excess of liabilities is balanced by the possession of other 
assets than cash. In other words, the assets of the bank 
are the liabilities of business men. The ultimate basis of 
the entire credit structure is kept out of sight, but the basis 
exists. Indeed, we may say that banking in a sense causes 
this visible, tangible wealth to circulate. If the acres of a 
landowner, or the iron stoves of a stove dealer cannot cir- 
culate in literally the same way that gold dollars circulate, 
yet the landowner or stove dealer may give to the bank a note 
on which the banker may base bank notes or deposits ; and 
these bank notes and deposits will circulate like gold dol- 
lars. Through banking, he who possesses wealth difficult 
to exchange can create a circulating medium. He has only 
to give his note, for which, of course, his property is liable, to 
a bank, get in return the right to draw, and lo ! his compara- 
tively unexchangeable wealth becomes Hquid currency. 
To put it crudely, banking is a device for coining into dollars 
land, stoves, and other wealth that is not otherwise generally 
exchangeable. 

It is interesting to observe that the formation of the great 
modern " trusts " has given a considerable impetus to de- 
posit currency ; for the securities of large corporations are 



l6o ELEMENTS OF ECONOMIC SCIENCE 

more easily used as a basis for bank loans than the stocks and 
bonds of small corporations or than partnership rights. 

We began by regarding a bank as substantially a coopera- 
tive enterprise, operated for the convenience and at the ex- 
pense of its depositors. But, as soon as it reaches the point 
of lending money to X, Y, and Z on time, while itself owing 
money on demand, it assumes toward X, Y, and Z and its 
cash depositors, risks which the depositors would be unwill- 
ing to assume. To meet this situation, the responsibility and 
expense of running the bank is taken by a third class of 
people, — stockholders, — who are willing to assume the 
augmented risk for the sake of the chance of profit. Stock- 
holders, in order to guarantee the depositors against loss, 
put in some cash of their own. Their contract is, in effect, 
to make good any loss to depositors. Let us suppose that 
the stockholders put in $50,000, — $40,000 in cash and 
$10,000 in the purchase of a bank building. The accounts 
now stand : — 

Assets Liabilities 

Cash $140,000 Due depositors . . $150,000 

Loans 100,000 Due note holders . . 50,000 

Building ..... 10,000 Due stockholders . . 50,000 

$250,000 $250,000 

§ 3. Banking Limitations 

We have seen that the assets must be adequate to meet 
the liabilities. We now observe that the form of the assets 
must be such as will insure meeting the Habilities promptly. 
Since the business of a bank is to furnish quickly available 
property (cash or credit) in place of the slower property of 
its depositors, it fails of its purpose when it is caught with 
insufficient cash. Yet it ' ' makes money ' ' partly by t)dng up 
its quick property, i.e. lending it out where it is less acces- 
sible. Its problem in poUcy is to tie up enough to increase 
its property, but not to tie up so much as to get tied up it- 
self. So far as anything has yet been said to the contrary, 



DEPOSIT CURRENCY l6l 

a bank might increase indefinitely its loans in relation to its 
cash or in relation to its capital. If this were so, deposit 
currency could be indefinitely inflated. There are limits, 
however, imposed by prudence and sound economic policy, 
on both these processes. Insolvency and insufficiency of 
cash must both be avoided. Insolvency is that condition 
which threatens when loans are extended with insufficient 
capital. Insufficiency of cash is that condition which 
threatens when loans are extended unduly relatively to cash. 
Insolvency is reached when the assets no longer cover the 
liabilities (to others than stockholders), so that the bank is 
unable to pay its debts at all. Insufficiency of cash is 
reached when, although the bank's total assets are fully 
equal to its liabilities, the actual cash on hand is insufficient 
to meet the needs of the instant, and the bank is unable to 
pay its debts on demand. 

The less the ratio of the value of the stockholders' inter- 
ests to the value of liabilities to others, the greater is the risk 
of insolvency ; the risk of insufficiency of cash is the greater, 
the less the ratio of the cash to the demand liabilities. In 
other words, the leading safeguard against insolvency lies in 
a large capital and surplus, but the leading safeguard against 
insufficiency of cash lies in a large cash reserve. Insolvency 
proper may befall any business enterprise. Insufficiency of 
cash relates especially to banks in their function of redeeming 
notes and deposits. 

Let us illustrate insufficiency of cash. In our bank's 
accounts as we left them there was a reserve of $140,000 of 
cash, and $200,000 of demand liabilities (deposits and notes). 
The managers of the bank may think this reserve of $140,000 
unnecessarily large or the loans unnecessarily small. They 
may then increase their loans (extended to customers in the 
form of cash, notes, or deposit accounts) until the cash re- 
serve is reduced, say to $40,000, and the liabilities due de- 
positors and note holders increased to $300,000. If, under 
these circumstances, some depositor or note holder demands 



1 62 ELEMENTS OF ECONOMIC SCIENCE 

$50,000 cash, immediate payment will be impossible. It is 
true that the assets still equal the liabilities. There is full 
value behind the $50,000 demanded ; but the understand- 
ing was that depositors and note holders should be paid in 
money and on demand. Were this not a stipulation of the 
deposit contract, the bank might pay the claims thus made 
upon it by transferring to its creditors the promissory notes 
due it from its debtors ; or it might ask the customers to 
wait until it could turn these securities into cash. 

Since a bank cannot follow either of these plans, it tries, 
where insufficiency of cash impends, to forestall this con- 
dition by " calling in " some of its loans, or if none can be 
called in, by selling some of its securities or other property 
for cash. But it happens unfortunately that there is a limit 
to the amount of cash which a bank can suddenly reahze. 
No bank could escape failure if a large percentage of its 
note holders and depositors should simultaneously demand 
cash payment. To keep its depositors in single file is part of 
its policy. The paradox of a panic is well expressed by the 
case of the man who inquired of his bank whether it had cash 
available for paying the amount of his deposit, saying, '' If 
you can pay me, I don't want it ; but if you can't, I do.'^ 
Such was the situation in 1907 in Wall Street. All the 
depositors at one time wanted to be sure their money '* was 
there." Yet it never is there all at one time. 

Since, then, insufficiency of cash is so troublesome a con- 
dition, — so difficult to escape when it has arrived, and so 
difficult to forestall when it begins to approach, — a bank 
must so regulate its loans and note issues as to keep on hand 
a sufficient cash reserve, and thus prevent insufficiency of 
cash from even threatening. It can regulate the reserve by 
alternately selling securities for cash and loaning cash on 
securities. The more the loans in proportion to the cash on 
hand, the greater the profits, but the greater the danger also. 
In the long run a bank maintains its necessary reserve by 
means of adjusting the interest rate charged for loans. If 



DEPOSIT CURRENCY 1 63 

it has few loans, and a reserve large enough to support loans 
of much greater volume, it will endeavor to extend its loans 
by lowering the rate of interest. If its loans are large, and it 
fears too great demands on the reserve, it will restrict the 
loans by a high interest charge. Thus, by alternately rais- 
ing and lowering the rate of interest, a bank keeps its loans 
within the sum which the reserve can support, but en- 
deavors to keep them (for the sake of profit) as high as the 
reserve will allow. 

The amount of reserve itself, however, must be propor- 
tioned to liabilities. If the sums owed to individual de- 
positors are large, relatively to the total liabilities, the re- 
serve should be proportionately large, since the action of a 
small number of depositors can deplete it rapidly. The 
reserve in a large city with great bank activity needs to be 
greater in proportion to its demand liabilities than in a small 
town with infrequent banking transactions. No absolute 
numerical rule can be given. Arbitrary ratios are often im- 
posed by law. National banks in the United States, for 
instance, are required to keep a reserve for their deposits, 
varying according as they are or are not situated in certain 
cities designated by law as " reserve " cities, i.e. cities where 
national banks hold deposits of banks elsewhere. These 
reserves are all in defense of deposits. In defense of notes, 
on the other hand, no cash reserve is required, — that is, of 
national banks. True, the same economic principles apply 
to both bank notes and deposits, but the law treats them 
differently. The government chooses to undertake to re- 
deem the national bank notes on demand. 

This legal regulation of banking reserves, however, is not 
a necessary nor a normal development of banking. Banking 
may exist without government regulations at all. 



164 ELEMENTS OF ECONOMIC SCIENCE 



§ 4. The Total Currency and its Circulation 

The study of banking operations, then, discloses two 
species of currency : one, bank notes, belonging to the 
category of money ; and the other, deposits, belonging 
outside of that category, but constituting an excellent sub- 
stitute. Referring these to the larger category of goods, 
we have a threefold classification of goods : first, money; 
second, deposit-currency, or simply deposits; and third, 
all other goods. And by the use of these, there are six pos- 
sible types of exchange : — 

(i) Money against money, 

(2) Deposits against deposits, 

(3) Goods against goods, 

(4) Money against deposits, 

(5) Money against goods, 

(6) Deposits against goods 

For our purpose, only the last two types of exchange are 
important, for these constitute the circulation of currency. 
As to the other four, the first and third have been previously 
explained as " money changing " and " barter " respec- 
tively. The second and fourth are banking transactions : 
the second being such operations as the selling of drafts for 
checks or the mutual cancellation of bank clearings; and 
the fourth being such operations as the depositing or with- 
drawing of money, by depositing cash or cashing checks. 

The analysis of the balance sheets of banks has prepared 
us for the inclusion of bank deposits or circulating credit 
in the equation of exchange. We shall still use M to express 
the quantity of actual money, and V to express the velocity 
of its circulation. Similarly, we shall now use M^ to express 
the total deposits subject to transfer by check ; and V\ to 
express the average velocity of their circulation. The total 
value of purchases in a year is therefore no longer to be 



DEPOSIT CURRENCY 1 65 

measured by MV, but by If F + M'V\ The equation of 
exchange, therefore, becomes 

MV + M'V' = tpQ. 

Let us again represent the equation of exchange by means 
of a mechanical picture. In Figure 9, trade, as before, is 
represented on the right by the weight of a miscellaneous 
assortment of goods; and their average price by the dis- 
tance to the right from the fulcrum, or the length of the 
arm on which this weight hangs. Again at the left, 




*• ■■^■■■^■■■^^■■■^■■'i:'''^''^'"^'-ii'''ii-l'''V''^:'-v Wi :^ i-^^^^^^ 




Fig. g. 

money {M) is represented by a weight in the form of a purse, 
and its velocity of circulation ( V) by its arm ; but now we 
have a new weight at the left, in the form of a bank book, to 
represent the bank deposits {M'). The velocity of circula- 
tion (F) of these bank deposits is represented by its dis- 
tance from the fulcrum or the arm at which the book hangs. 

This mechanism makes clear the fact that the average price 
(right arm) increases with the increase of money or bank de- 
posits and with the velocities of their circulation, and de- 
creases with the increase in the volume of trade. 

Recurring to the left side of the equation of exchange, 
or ilf F + M' V\ we see that in a community without bank 
deposits the equation reduces simply to MV, the formula of 
Chapter VIII; for in such a community^ the term M'V^ 
vanishes. 

§ 5. Deposit Currency Normally Proportional to Money 

With the extension of the equation of monetary circula- 
tion to include deposit circulation, the influence exerted by 



1 66 ELEMENTS OF ECONOMIC SCIENCE 

the quantity of money on general prices becomes less direct ; 
and the process of tracing this influence becomes more dif- 
ficult and compHcated. It has even been argued that this 
interposition of circulating credit breaks whatever connec- 
tion there may be between prices and the quantity of money. 
This would be true if circulating credit were independent of 
money. But the fact is, as we have seen, that the quantity 
of circulating credit, M', tends to hold a definite relation to 
M, the quantity of money in circulation, — that is, deposits 
are normally a more or less definite multiple of money. 

Two facts normally give deposits a more or less definite 
ratio to money. The first has been already explained, viz. 
that bank reserves are kept in a more or less definite ratio to 
bank deposits. The second is that individuals, firms, and 
corporations preserve more or less definite ratios between 
their cash transactions and their check transactions, and also 
between their money and deposit balances. These ratios 
are determined by motives of individual convenience and 
habit. In general, business firms use money for wage pay- 
ments, and for small miscellaneous transactions included 
under the term " petty cash " ; while for settlements with 
each other they usually prefer checks. These preferences 
are so strong that we could not imagine them overridden 
except temporarily and to a small degree. A business firm 
would hardly pay car fares with checks and Kquidate its 
large liabilities with cash. Each person strikes an equilibrium 
between his use of the two methods of payment, and does 
not greatly disturb it except for short periods of time. He 
keeps his stock of money or his bank balance in constant 
adjustment to the payments he makes in money or by check. 
Whenever his stock of money becomes relatively small and 
his bank balance relatively large, he cashes a check. In the 
opposite event, he deposits cash. In this way he is con- 
stantly converting one of the two media of exchange into the 
other. A private individual usually feeds his purse from 
his bank account ; a retail commercial firm usually feeds its 



DEPOSIT CURRENCY 1 67 

bank account from its till. But for both these depositors 
the bank acts as intermediary. 

In a given community the quantitative relation of deposit 
currency to money is determined by several considerations of 
convenience. In the first place, the more highly developed 
the business of a community, the more prevalent the use of 
checks. Where business is conducted on a large scale, mer- 
chants habitually transact their larger operations with each 
other by means of checks, and their smaller transactions by 
means of cash. Again, the more concentrated the popula- 
tion, the more prevalent the use of checks. In cities it is 
more convenient both for the payer and the payee to make 
large payments by check ; whereas, in the country, trips to a 
bank are too expensive in time and effort to be convenient, 
and therefore more money is used in proportion to the 
amount of business done. Again, the wealthier the mem- 
bers of the community , the more largely will they use checks. 
Laborers seldom use them ; but capitaHsts, professional and 
salaried men use them habitually, for personal as well as 
business transactions. 

There is, then, a relation of convenience and custom be- 
tween check and cash circulation, and a more or less stable 
ratio between the deposit balance of the average man or 
corporation and the stock of money kept in pocket or till. 
This fact, as applied to the country as a whole, means that by 
convenience a rough ratio is fixed between M and M\ If 
that ratio is disturbed temporarily, there will come into play 
a tendency to restore it. Individuals will deposit surplus 
cash, or they will cash surplus deposits. 

Hence, both money in circulation (as just shown) and 
money in reserve (as shown previously) tend to keep in a 
fixed ratio to deposits. It follows that the two must be in a 
fixed ratio to each other. As to the adjustment or ratio 
of bank reserves to bank deposits, this evidently varies for 
different banks. In the United States a reserve is required 
by law, and the ratio insisted on differs according as the 



1 68 ELEMENTS OF ECONOMIC SCIENCE 

banks are ordinary national banks, national banks in reserve 
cities, or in central reserve cities, state banks, private 
banks, or trust companies. But even were there no legal 
requirement, experience would doubtless dictate differently 
the average size of deposit accounts for different banks ac- 
cording to the general character and amount of their busi- 
ness. For every bank there is a normal ratio, and hence for 
a whole community there is also a normal ratio, — an aver- 
age of the ratios for the different banks. 

§ 6. Summary 

The contents of this chapter may be formulated in a few 
simple propositions : — 

(i) Banks supply two kinds of currency, viz. bank notes 

— which are money ; and bank deposits (or rights to draw) 

— which are not money. 

(2) A bank check is m-crely a certificate of a right to 
draw. 

(3) Behind the claims of depositors and note holders 
stands not simply the cash reserve but all the assets of the 
bank. 

(4) Deposit banking is a device by which wealth, inca- 
pable of direct circulation, may be made the basis of the 
circulation of rights to draw. 

(5) The basis of such circulating rights to draw or de- 
posits must consist in part of actual money, and it should 
consist in part also of quick assets readily exchangeable for 
money. 

(6) Six sorts of exchange exist among three classes of 
goods, money, deposits, and other goods. Of these six sorts 
of exchange, the most important for our present purposes 
are the exchanges of money and deposits against goods. 

(7) The equation of money circulation extended so as to 
make it include bank deposits reads thus : MV + M^V^ = 
tpQ. 



DEPOSIT CURRENCY 1 69 

(8) The relation of bank deposits (If') to the quantity of 
money (M) has already been discussed, and we have seen 
that there must exist between bank deposits and money a 
normal ratio ; because, in the first place, cash reserves are 
necessary to support bank deposits, and these reserves must 
bear some more or less constant ratio to the amount of 
such deposits ; and because, in the second place, business 
convenience dictates that the available currency shall be 
apportioned between deposits and money in a certain more 
or less definite, even though elastic, ratio. 



CHAPTER X 

THE EQUATION OF EXCHANGE DURING TRANSITION PERIODS 

§ I. The Tardiness of Interest Adjustment to Price 
Movements 

In the last chapter it was shown that the quantity of 
bank deposits normally maintains a definite ratio to the 
quantity of money in circulation and to the amount of bank 
reserves. As long as this normal relation holds, the exist- 
ence of bank deposits merely magnifies the effect on the 
level of prices produced by the quantity of money in cir- 
culation and does not in the least distort that effect. 
Moreover, changes in velocity or trade will have the same 
effect on prices, whether bank deposits are included or not. 

But during periods of transition this relation between 
money {M) and deposits {M') is by no means rigid. 

We are now ready to study these periods of transition. The 
change which constitutes a transition may be a change in the 
quantity of money, or in any other factor of the equation of 
exchange, or in all. Usually all are involved, but the chief 
factor which we shall select for study (together with its 
effects on the other factors) is quantity of money. If the 
quantity of money were suddenly doubled, the effect of the 
change would not be the same at first as later. The ultimate 
effect is, as we have seen, to double prices ; but before this 
happens, the prices oscillate up and down. In this chap- 
ter we shall consider the temporary effects during the period of 
transition separately from the permanent or ultimate effects 
which were considered in the last chapter. These perma- 
nent or ultimate effects follow after a new equilibrium is es- 
tabhshed, — if, indeed, such a condition as equihbrium may 

170 



EQUATION OF EXCHANGE DURING TRANSITION PERIODS 171 

ever be said to be established. What we are concerned with 
in this chapter is the temporary effects, i.e. those in the 
transition period. 

The transition periods may be characterized either by 
rising prices or by falling prices. Rising prices must be 
clearly distinguished from high prices, and Jailing from low. 
With stationary levels, high or low, we have in this chapter 
nothing to do. Our concern is with rising or faUing prices. 
Rising prices mark the transition between a low and a high 
level of prices, just as a hill marks the transition between flat 
lowlands and flat highlands. Since the study of these ac- 
chvities and decKvities is bound up with that of the adjust- 
ment of interest rates, our first task is to present a brief 
statement regarding the effects of rising and falKng prices 
on the rate of interest. Indeed, the chief object of this 
chapter is to show that the pecuhar behavior of the rate of 
interest during transition periods is largely responsible for 
the crises and depressions in which price movements end. 

It must be borne in mind that although business loans are 
made in the form of money, yet whenever a man borrows 
money he does not do this in order to hoard the money, but to 
purchase goods with it. To all intents and purposes, there- 
fore, when A borrows one hundred dollars from B in order 
to purchase, say, one hundred units of a given commodity at 
one dollar per unit, it may be said that B is virtually lending 
A one hundred units of that commodity. And if at the end 
of a year A returns one hundred dollars to B, but the price 
of the commodity has meanwhile advanced, then B has lost 
a fraction of the purchasing power originally loaned to A. 
For even though A should happen to return to B the iden- 
tical coins in which the loan was made, these coins represent 
somewhat less than the original quantity of purchasable 
commodities. Bearing this in mind in our investigation of 
interest rates, let us suppose that prices are rising at the 
rate of 3 per cent each year. It is plain that the man who 
lends $100 at the beginning of the year, must, in order to get 



172 ELEMENTS OF ECONOMIC SCIENCE 

5 per cent interest in purchasing power, receive back both 
$103 (then the equivalent of the $100 lent) plus 5 per cent of 
this, or a total of $108.15. That is, in order to get 5 per cent 
interest in actual purchasing power, he must receive a Httle 
more than 8 per cent interest in money. The 3 per cent rise 
of prices thus adds approximately 3 per cent to the rate of 
interest. Rising prices, therefore, in order that the relations 
between creditor and debtor shall be the same during the rise 
as before and after, require higher money interest than sta- 
tionary prices require. Not only will lenders demand higher 
interest in terms of money, but borrowers can afford to pay 
it; and to some extent competition will gradually force 
them to do so. Yet we are so accustomed in our business 
deahngs to consider money as the one thing stable, — to 
think of a " dollar as a dollar " regardless of the passage of 
time, — that we reluctantly yield to this process of read- 
justment, thus rendering it very slow and imperfect. When 
prices are rising at the rate of 3 per cent a year, and the 
normal rate of interest, i.e. the rate which would exist were 
prices stationary, is 5 per cent, the actual rate, though it 
ought (in order to make up for the rising prices) to be 8.15 
per cent, will not ordinarily reach that figure ; but it may 
reach, say, 6 per cent, and later, 7 per cent. This inadequacy 
and tardiness of adjustment, is fostered, moreover, by law 
and custom, which arbitrarily tend to keep down the rate 
of interest, even though, at the prevailing rate, the demand 
for money exceeds the supply. A similar inadequacy of 
adjustment is observed when prices are falling. Suppose 
that, by the end of a year, $97 will buy as much as $100 at 
the beginning. In that case the lender, in order to get back 
a purchasing power equivalent to his principal and 5 per 
cent interest, should get, not $105, but only $97 -f 5 per 
cent of $97 or $101.85. Thus the rate of interest in money 
should in this case be 1.85 per cent or less than 2 per cent. 
In other words, the 3 per cent fall of prices should reduce the 
rate of interest by approximately 3 per cent. But as a 



EQUATION OF EXCHANGE DURING TRANSITION PERIODS 1 73 

matter of fact, such a perfect adjustment is seldom reached, 
and money interest keeps far above 2 per cent for a consider- 
able time. 

§ 2. How a Rise of Prices generates a Further Rise 

We are now ready to study temporary or transitional 
changes in the factors of our equation of exchange. Let us 
begin by assuming a shght initial disturbance, such as would 
be produced, for instance, by an increase in the quantity of 
gold. This will cause a rise in prices. The rate of interest 
will not respond immediately. As prices rise, profits of busi- 
ness men measured in money will rise also, even if the costs of 
business rise in the same proportion. Thus, if a man who 
sold $10,000 of goods at a cost of $6000, thus clearing $4000, 
can get double prices at double cost, his profit will be double 
also, being $20,000 — $12,000, which is $8000. Of course such 
a rise of prices is purely nominal, as it merely keeps pace with 
the rise in price level. The business man gains no advan- 
tage, for his larger money profits will buy no more than his 
former smaller money profits bought. But if among his 
costs is interest, and this cost does not rise, the profits will 
rise faster than prices. Consequently, he will find himself 
making greater profits than usual, and be encouraged to 
expand his business by increasing his borrowings. These 
borrowings are mostly in the form of short-time loans by 
banks ; and, as we have seen, short-time loans are in the 
form of deposits. Therefore, deposit currency {M') will 
increase, but this extension of deposit currency tends further 
to raise the general level of prices, just as the increase of gold 
raised it in the first place. Hence prices, which were already 
outstripping the rate of interest, tend to outstrip it still fur- 
ther, enabhng borrowers, who were already increasing their 
profits, to increase them still further. Borrowing, already 
stimulated, is stimulated still further ; more loans are 
demanded, and although nominal interest may be forced up 



174 ELEMENTS OF ECONOMIC SCIENCE 

somewhat, still it keeps lagging below the normal level. 
Yet nominally, the rate of interest has increased ; and hence 
the lenders too, including banks, are led to become more 
enterprising. Led by the higher nominal rates into the 
belief that fairly high interest is being realized, they extend 
their loans, and with the resulting expansion of bank loans, 
deposit currency {M'), already expanded, expands still 
more. Hence prices rise still further. This sequence of 
events may be briefly stated as follows : — 

1. Prices rise (whatever the first cause may be, but we 
have chosen for illustration an increase in the amount of 
gold.) 

2. The rate of interest rises, but not sufi&ciently. 

3. Enterpriser-borrowers, encouraged by large profits, 
expand their loans. 

4. Deposit currency {M') expands relatively to money 
{M). 

5. Prices continue to rise, that is, phenomenon No. i is 
repeated. 

Then No. 2 is repeated, and so on. 

In other words, a slight initial rise of prices sets in motion 
a train of events which tends to repeat itself. Rise of prices 
generates rise of prices, and continues to do so as long as the 
interest rate lags behind its normal figure. 

§ 3. How a Rise of Prices culminates in a Crisis 

The expansion in deposit currency indicated in this cycle 
of events abnormally increases the ratio of M' to M. 

This, however, is not the only disturbance caused by the 
increase in M. There are disturbances in the Q's, in F, and 
in V\ These will be taken up in order. Trade (the Q's) 
will be stimulated by the easy terms for loans. This effect is 
always noted during rising prices, and people note approv- 
ingly that " business is good " and " times are booming." 
Such statements represent the point of view of the ordinary 



EQUATION OF EXCHANGE DURING TRANSITION PERIODS 1 75 

business man who is an " enterpriser-borrower." They do 
not represent the sentiments of the creditor, the salaried 
man, or the laborer, most of whom are silent but long-suffer- 
ing — paying higher prices but not getting proportionally 
higher incomes. 

The increase in business on the one hand and the increase 
in deposits on the other hand do not exactly offset each 
other, as experience abundantly proves. The increase in 
deposits will outweigh the increase in trade. This becomes 
evident when we consider that the added deposits found 
their origin in loans that were intended to finance new opera- 
tions. Usually the added trade for which the deposit was 
created requires the expenditure of that deposit only once. 
But the deposit once created is apt to last a long time. After 
it is spent by the men who created it, it goes to swell the de- 
posit accounts of others. It is like new gold coin which, after 
the gold miner has once put it into circulation, continues in 
circulation indefinitely. * The gold miner may expend it for 
mining expenses which help to make a demand for the new 
coins it brings into circulation, but the new gold will be used 
more than once ; and for all uses beyond the first, no new 
transactions have been especially created for its continued 
expenditure. The new deposit currency Hkewise, when once 
originated by the loan for new business, does not thereafter 
find enough '' new work " to do to keep it busy. That is, 
the new deposit currency (MO adds more to the left side of 
the equation than the trade which gave it birth adds to 
the right side. Consequently, the net effect is to increase 
the price level. 

We next observe that the rise in prices — fall in the pur- 
chasing power of money — will accelerate the circulation of 
money. We all hasten to get rid of any commodity which, 
like ripe fruit, is spoiling on our hands. Money is no excep- 
tion. When it is depreciating, holders will get rid of it as 
fast as possible. As they view it, their motive is to buy 
goods which appreciate in terms of money. The inevitable 



176 ELEMENTS OF ECONOMIC SCIENCE 

result is that these goods rise in price still further. The 
series of changes, then, initiated by rising prices, expressed 
more fully than before, is as follows : — 

1. Prices rise. 

2. Velocities of circulation (F and F') increase ; the rate 
of interest rises, but not sufficiently. 

3. Loans expand and the ^'s increase. 

4. Deposit currency (M') expands relatively to money 
(M). 

5. Prices continue to rise ; that is, phenomenon No. i is 
repeated. 

Then No. 2 is repeated, and so on. 

It will be noticed that these changes now involve all mag- 
nitudes in the equation of exchange. They are temporary 
changes, pertaining only to the transition period. They are 
like temporary increases in power and readjustments in the 
position of an autompbile cUmbing a hill. 

Evidently the expansion coming from this cycle of causes 
cannot proceed forever. It must ultimately spend itself. 
The check upon its continued operation Hes in the rate 
of interest. It was the tardiness of the rise in interest 
that was responsible for the abnormal condition. But the 
rise in interest, though belated, is progressive, and, as soon as 
it overtakes the rate of rise in prices, the whole situation is 
changed. If prices are rising at the rate of 2 per cent per 
annum, the boom will continue only until interest becomes 
2 per cent higher. It then offsets the rate of rise in prices. 
The banks are forced in seK-defense to raise interest because 
they cannot stand so abnormal an expansion of loans rel- 
atively to reserves. As soon as the interest rate becomes 
adjusted, borrowers can no longer hope to make great profits, 
and the demand for loans ceases to expand. 

There are also other forces resisting further expansion of 
deposit currency and tending to contraction. But those 
above mentioned are the most important. 

With the rise of interest, those who have counted on re- 



EQUATION OF EXCHANGE DURING TRANSITION PERIODS 1 77 

newing their loans at the former rates and for the former 
amounts are unable to do so. Some of them are destined to 
fail. The failure (or prospect of failure) of firms that have 
borrowed heavily from banks induces fear on the part of 
many depositors that the banks will not be able to reahze on 
these loans. Hence, the banks themselves fall under sus- 
picion, and for this reason depositors demand cash. Then 
occur " runs on the banks," which deplete the bank reserves 
at the very moment they are most needed. Being short of 
reserves the banks have to curtail their loans. It is then 
that the rate of interest rises to a panic figure. Those who 
are caught must have currency to liquidate their obligations, 
and to get it are wilKng to pay high interest. Some of them 
are destined to become bankrupt, and, with their failure, 
the demand for loans is correspondingly reduced. This 
culmination of an upward price movement is what is called 
a crisis, — a condition characterized by bankruptcies, and 
the bankruptcies being due to a lack of cash when it is most 
needed. 

Then a curious thing happens : borrowers, unable to get 
easy loans, blame the high rate of interest for conditions 
which were really due to the fact that the previous rate of 
interest was not high enough. Had the previous rate been 
high enough, they never would have overinvested. 

§ 4. Completion of the Credit Cycle 

The contraction of loans and deposits, and the decrease in 
velocities, prevent a further rise of prices and tend toward a 
fall. The crest of the wave is reached and a reaction sets in. 
Since prices have stopped rising, the rate of interest, which 
has risen to compensate the rise of prices, should fall again. 
But, just as at first it was slow to rise, so now it is slow to fall. 
In fact, it tends for a time to rise still further. Even when 
interest begins to fall, it falls slov/ly, and failures continue 
to occur. Borrowers now find that interest, though nomi- 



178 ELEMENTS OF ECONOMIC SCIENCE 

nally low, is still hard to meet. Bank loans tend to be low, and 
consequently deposits (M^) are reduced. The contraction 
of deposit currency makes prices fall still more. Those who 
have borrowed for the purpose of buying stocks of goods, 
now find they cannot sell them for enough to pay back what 
they have borrowed. Owing to this tardiness of the interest 
rate to fall to a lower and a normal level, the sequence of 
events is now the opposite of what it was before : — 

1. Prices fall. 

2. The rate of interest falls, but not sufficiently. 

3. Enterpriser-borrowers, discouraged by small profits, 
contract their borrowings. 

4. Deposit currency (if') contracts relatively to money 
(M). 

5. Prices continue to fall; that is, phenomenon No. i is 
repeated. 

Then No. 2 is repeated, and so on. 

Thus a fall of prices generates a further fall of prices. 
The cycle evidently repeats itself as long as the rate of in- 
terest lags behind. The man who loses most is the business 
man in debt. He is the t^^pical business man, and he now 
complains that " business is bad." There is a '' depression 
of trade." 

During this depression velocities (F and V') are abnor- 
mally low. People are less hasty to spend money or check- 
when the dollars they represent are rising in purchasins 
power. Also trade (the Q's) decKnes. A statement includ- 
ing these factors is : — 

1. Prices fall. 

2. Velocities of circulation (V and F') fall; the rate of 
interest falls, but not sufficiently. 

3. Loans and the Q's decrease. 

4. Deposit currency (M') contracts relatively to money 

w- _ _ 

5. Prices continue to fall ; that is, phenomenon No. i is 
repeated. 



EQUATION OF EXCHANGE DURING TRANSITION PERIODS 1 79 

Then No. 2 is repeated, and so on. 

The contraction brought about by this cycle of causes be- 
comes self-Hmiting as soon as the rate of interest overtakes 
the rate of fall in prices. After a time, normal conditions 
begin to return. The weakest producers have been forced 
out, or have at least been prevented from expanding their 
business by increased loans. The strongest firms are left 
to build up a new credit structure. Borrowers again become 
willing to take ventures. Failures decrease in number. 
Bank loans cease to decrease. Prices cease to fall. Bor- 
rowing and carrying on business becomes profitable ; loans 
are again demanded; prices again begin to rise, and there 
occurs a repetition of the upward movement already de- 
scribed. 

The upward and downward movements taken together 
constitute a complete credit cycle, which resembles the for- 
ward and backward movements of a pendulum. 

We have considered the rise, culmination, fall, and re- 
covery of prices. These changes are abnormal oscilla- 
tions, due to some initial disturbance. In most cases the 
time occupied by the swing of the commercial pendulum to 
and fro is about ten years. While the pendulum is continu- 
ally seeking a stable position, practically there is almost 
always some occurrence to prevent perfect equilibrium. 
Oscillations are set up which, though tending to be self- 
corrective, are continually perpetuated by fresh disturb- 
ances. The factors in the equation of exchange are there- 
fore continually seeking norm^al adjustment. A ship in a 
calm sea will " pitch " only a few times before coming to 
rest. But in a high sea the pitching never ceases. While 
continually seeking equilibrium, the ship continually en- 
counters causes which accentuate the oscillation. 



CHAPTER XI 

INFLUENCES OUTSIDE THE EQUATION 

§ I. Influences which Conditions of Production exert on 
Trade and therefore on Prices 

Thus far we have considered the level of prices as affected 
by the volume of trade, by the velocity of circulation of 
money and of deposits, and by the quantity of money and 
of deposits. These are the only influences which can di- 
rectly affect the level of prices. Any other influences on 
prices must act through these three. There are myriads of 
such influences (outside of the equation of exchange) that 
affect prices through the medium of these three. It is our 
purpose in this chapter to note the chief among them, ex- 
cepting those that affect the volume of money (M) ; the 
latter will be examined in the next chapter. 

We shall first consider the outside influences that affect 
the volume of trade and through it the price level. The 
conditions which determine the extent of trade are numer- 
ous and technical. The most important may be classified as 
follows : — 

1. Conditions affecting producers. 

(a) Geographical differences in natural resources. 

(b) The division of labor. 

(c) Knowledge of the technique of production. 

(d) The accumulation of capital. 

2. Conditions affecting consumers, 

(a) The extent and variety of human wants. 
1 80 



INFLUENCES OUTSIDE THE EQUATION l8l 

3. Conditions connecting producers and consumers. 
(a) Facilities for transportation. 
ih) Relative freedom of trade. 

(c) Character of monetary and banking systems. 

(d) Business confidence. 

I. {a) It is evident that if all localities were exactly ahke 
in their natural resources and in other comparative costs of 
production, no trade would be set up between them. It is 
equally true that the greater the difference in the costs of 
production of different articles in different locahties, the 
more likely is there to be trade between them, and the greater 
the amount of that trade. Primitive trade had its rats on 
d^etre in the fact that the regions of this earth are unhke in 
their products. The traders were travelers between distant 
coimtries. Changes in commercial geography still produce 
changes in the distribution and volume of trade. The ex- 
haustion of the gold and silver mines in Nevada and of lum- 
ber in Michigan have tended to reduce the volume of trade 
of these regions, both external and internal. Contrariwise, 
cattle raising in Texas, the production of coal in Pennsyl- 
vania, of oranges in Florida, and of apples in Oregon, has 
increased the volume of trade for these communities re- 
spectively. 

I. (6) Equally obvious is theinfiuence of the division of 
labor, i.e. the differentiation of productive activity among 
men. Division of labor is based in part on difference in 
comparative costs as between men, — corresponding to 
geographic differences as between countries. These two 
combined lead to local differentiation of labor, making, for 
example, the town of Sheffield famous for cutlery, Dresden 
for china, Venice for glass, Patterson for silks, and Pittsburg 
for steel. 

I. {c) Besides local and personal differentiation, the state 
of knowledge of production will stimulate trade. The mines 
of Africa £ind Austraha were left unworked for centuries by 



152 ELEMENTS OE ECONOMIC SCIENCE 

ignorant natives, but were opened by white men possessing 
a knowledge of metallurgy. Vast coal fields in China await 
development, largely for lack of knowledge of how to ex- 
tract and market the coal. Egypt awaits the advent of 
scientific agriculture to usher in trade expansion. Nowa- 
days, trade schools in Germany, England, and the United 
States are increasing and diffusing knowledge of productive 
technique. 

1. {d) But knowledge, to be of use, must be appKed ; and 
its application usually requires the aid of capital. The 
greater and the more productive the stock of capital 
in any community, the more goods it can put into 
the channels of trade. A mill will make a town a center 
of trade. Docks, elevators, warehouses, and railway ter- 
minals, help to transform a harbor into a port of 
commerce. 

Since increase in trade tends to decrease the general level 
of prices ; anything which tends to increase trade likewise 
tends to decrease the general level of prices. We conclude, 
therefore, that among the causes tending to decrease prices 
are: increasing geographical or personal specialization; 
improved productive technique; and the accumulation of 
capital. 

2. {a) Turning to the consumer's side, it is evident that 
their wants change from time to time. This is true even 
of so-called natural wants, but more conspicuously true of 
acquired or artificial wants. 

Wants are, as it were, the mainsprings of economic activ- 
ity which in the last analysis keep the economic world in 
motion. The desire to have clothes as fine as the clothes 
of others, or finer, or different, leads to the multiplicity of 
silks, satins, laces, etc. ; and the same principle appUes to 
furniture, amusements, books, works of art, and every other 
means of gratification. 

The increase of wants, by leading to an increase in 
trade, tends to lower the price level. 



I2OTLUENCES OUTSIDE THE EQUATION 1 83 



§ 2. Influence of Conditions connecting Producers and 
Consumers on Trade and therefore on Prices 

3, {a) Anything which facihtates intercourse tends to 
increase trade. Anything that interferes with intercourse 
tends to decrease trade. First of all should be mentioned 
the mechanical faciUties for transport. As Macaulay said, 
with the exception of the alphabet and the printing press, 
no set of inventions has tended to alter civilization so much 
as those which abridge distance, — such as the railway, the 
steamship, the telephone, the telegraph, and that conveyer 
of information and advertisements, the newspaper. These 
all tend to increase trade and therefore to decrease 
prices. 

3. (h) Trade barriers are not only physical but legal. A 
tariff between countries has the same influence in decreasing 
trade as a chain of mountains. The freer the trade, the more 
of it there will be. In France, many communities have a 
local tariff ('' octroi ") which tends to interfere with local 
trade. In the United States, trade is free within the country 
itself, but between the United States and other countries 
there is a high protective tariff. The very fact of increasing 
facilities for transportation, lowering or removing physical 
barriers, has stimulated nations and communities to erect 
legal barriers in their place. Tariffs not only tend to decrease 
the frequency of exchanges, but, to the extent that they 
prevent international or interlocal division of labor and make 
countries more alike as well as less productive, they also tend 
to decrease the amounts of goods which can be exchanged. 
The ultimate effect is thus to raise prices. 

3. (c) The development of efficient monetary and banking 
systems tends to increase trade. There have been times in 
the history of the world when the money was in so uncertain 
a state that people hesitated to make many trade contracts 
because of the lack of knowledge of what would be required 



184 ELEMENTS OF ECONOMIC SCIENCE 

of them when the contract should be fulfilled. In the same 
way, when people cannot depend on the good faith or sta- 
bihty of banks, they will hestitate to use deposits and 
checks. 

3. (d) Confidence, not only in banks in particular but 
in business contracts in general, is truly said to be "the soul 
of trade." Without confidence there cannot be a great 
volume of contracts. Anything that tends to increase this 
confidence tends to increase trade. In South America 
there are many places waiting to be developed simply 
because capitalists do not feel any security in contracts 
there. They are fearful that by hook or by crook the 
fruit of any investments they may make will be taken from 
them. 

We see, then, that prices will tend to fall through an in- 
crease in trade, which may in turn be brought about by 
improved transportation, by increased freedom of trade, by 
improved monetary and banking systems, and by business 
confidence. 

The external trade of any country is intimately connected 
with its internal trade. An increase of the former may cause 
an increase in the latter. Industry planted in any locaUty 
for the purpose of trading with distant locahties will bring 
with it all kinds of supplementary commerce, so that the 
locaHty will become a market for many sorts of goods. 

Through the various causes mentioned, trade has been 
increasing for centuries; and the history of ci\dlization is 
largely the history of increasing trade. The discovery of 
new lands, the specialization of their products, division of 
labor, invention, and the improvement of industrial tech- 
nique, the accumulation of capital, increased complexity of 
human wants, cheapened transportation and communication, 
development of better monetary and banking systems, and 
greater confidence, have, in spite of higher tariff walls, 
worked toward lower price levels ; and the future promises 
a still further expansion of trade. 



INFLUENCES OUTSIDE THE EQUATION 185 

§ 3. Influence of Individual Habits on Velocities of 
Circulation and therefore on Prices 

Our next task is to consider those causes outside of the 
equation of exchange that affect the velocities of circulation 
of money and of deposits. For the most part, the causes 
affecting one of these also affect the other. These causes 
may be classified as follows : — 

1. Habits of the individual. 

(a) As to thrift and hoarding. 

(b) As to book credit. 

(c) As to the use of checks. 

2. Systems of payments in the community. 

(a) As to frequency of receipts and of disbursements. 

(b) As to regularity of receipts and of disbursements. 

(c) As to correspondence between times and amounts 

of receipts and of disbursements. 

3. General causes. 

(a) Density of population. 

(b) Rapidity of transportation. 

I. (a) Taking these up in order, we may first consider 
what influence thrift has on the velocity of circulation. 
Velocity of money is the same thing as the rate of turnover of 
money. It was found by dividing the total payments ef- 
fected by money in a year by the amount of money in circu- 
lation in that year. It depends upon the rates of turnover 
of the individuals which compose the society. This velocity 
of circulation or rapidity of turnover of money is the greater 
for each individual the more he spends with a given average 
amount of cash on hand or the less average cash he keeps 
for a given yearly expenditure. Great is the velocity of 
circulation of a spendthrift. He tends to be " short " of 



l86 ELEMENTS OE ECONOMIC SCIENCE 

funds — to have a small average balance on hand. But his 
thrifty neighbor takes care to provide himself with cash 
enough to meet all contingencies. The latter tends to hoard 
and lay by his money, and will therefore have a slower velocity 
of circulation. When, as used to be the custom in France, 
people put money away in stockings and kept it there for 
months, the velocity of circulation must have been extremely 
slow. The same principle apphes to deposits. Oftentimes 
in a certain university town the banks either refuse to take 
deposits from students of spending habits because the aver- 
age balances of the latter are so low, or insist on a special 
stipulation that the balances shall never fall below one hun- 
dred dollars. 

Hoarded money is sometimes said to be withdrawn from 
circulation. This is only another way of saying that hoard- 
ing tends to decrease the velocity of circulation. 

A man who is thrifty is usually to some extent a hoarder 
either of money or of bank deposits. Laborers who save 
keep their savings, usually in the form of money, until 
enough is accumulated to be deposited in a savings bank. 
Those who have bank accounts will hkewise accumulate 
considerable deposits when preparing to make an invest- 
ment. Banks whose depositors are " rapidly making 
money " and periodically investing the same, have, it is 
said, less active accounts than banks whose depositors " hve 
up to their incomes." 

I. (b) The habit of " charging," or book credit, tends to 
increase the velocity of circulation of money, because the 
man who gets things " charged " does not need to keep on 
hand as much money as he would if he made all payments 
in cash. A man who daily pays cash needs to keep cash for 
daily contingencies. The system of cash payments, unlike 
the system of book credit, requires that money shall be kept 
on hand in advance of purchases. Evidently, if money must 
be provided in advance, it must be provided in larger quan- 
tities than when merely required to liquidate past debts. In 



ESTFLUENCES OUTSIDE THE EQUATION 187 

the system of cash payments a man must keep money idle 
in advance, lest he be caught in the embarrassing position of 
lacking it when he most needs it. With book credit he 
knows that even if he should be caught without a cent in his 
pocket, he can still get supplies on credit. These he can pay 
for when money comes to hand. Moreover, this money 
need not he long in his pocket. Immediately it is received, 
there is a use awaiting it to pay debts accumulated. For 
instance, a laborer receiving and spending $7 a week, if he 
cannot '' charge," must make his week's wages last through 
the week. If he spends $i a day, his weekly cycle must 
show on successive days at least as much as $7, $6, $5, $4, $3, 
$2, and $1, at which time another $7 comes in. This makes 
an average of at least $4. But if he can charge everything, 
and then wait until pay day to meet the resulting obhgations, 
he need keep nothing through the week, paying out his $7 
when it comes in. His weekly cycle need show no higher 
balances than $7, $0, $0, |o, $0, $0, $0, the average of which 
is only $1. 

Through book credit, therefore, the average amount of 
money or bank deposits which each person must keep at 
hand to meet a given expenditure is made less. This means 
that the rate of turnover is increased. 

I. {c) The habit of using checks, rather than money, will 
also affect the velocity of circulation, because a depositor's 
surplus money will immediately be put in the bank in return 
for a right to draw by check. 

Banks thus offer an outlet for any surplus pocket money 
or surplus till money, and thus tend to prevent the existence 
'of idle hoards. In hke manner, surplus deposits may be 
converted into cash — that is, exchanged for cash — as 
desired. In short, those who make use both of cash and de- 
posits may, by adjusting the two, prevent either from being 
idle. 

We see, then, that these habits — spendthrift habits, the 
habit of charging, and the habit of using checks — all tend 



1 88 ELEMENTS OF ECONOMIC SCIENCE 

to raise the level of prices through their effects on the velocity 
of circulation, of money, or of deposits. It is believed that 
these habits (except probably the first) have been increasing 
rapidly during modern times. 

§ 4. Influence of Systems of Payments on Velocities of 
Circulation and therefore on Prices 

2. (a) The more frequently money or checks are received 
and disbursed, the shorter is the average interval between 
the receipt and the expenditure of money or checks, and the 
more rapid is the velocity of circulation. 

This may best be seen from an example. A change from 
monthly to weekly wage payments tends to increase the ve- 
locity of circulation of money. If a laborer is paid weekly $7, 
and reduces this evenly each day, ending each week empty- 
handed, his average cash on hand will be a little over half of 
$7, or about $4. This makes his rate of turnover nearly 
twice a week. Under monthly payments, the laborer who 
receives and spends an average of $1 a day will have to 
spread the $30 evenly over the following 30 days. If' at the 
next pay day, he comes out empty-handed, his average 
money during the month has been $15. This makes his 
turnover nearly twice a month. Thus the rate of turnover 
is more rapid under weekly than under monthly payments. 

The same result would hold if we assumed that, instead of 
ending the cycle empty-handed, he ended it with a given 
fraction — say half — of his wages unspent. Under weekly 
payments, he would begin with $10.50, and end with $3.50, 
averaging about $7. Under monthly payments he would 
thus begin with an average of $45, and end with $15, aver- 
aging about $30. In the former case his average velocity of 
circulation would be once a week, and in the latter once a 
month. The turnover would still be about four times as 
rapid under weekly as under monthly payments. Thus, 
if the distribution of expenditure over the two cycles should 



INFLUENCES OUTSIDE THE EQUATION 1 89 

have exactly the same " time shape " (distribution in 
time), weekly payments would accelerate the velocity of 
circulation in the same ratio which a month bears to a week. 
As a matter of history, however, we cannot be sure whether 
the substitution of weekly payments has increased the 
rapidity of circulation of money among workingmen four- 
fold, because the change in another element, book credit, 
would be likely to cause a somewhat compensatory decrease. 
Book credit is more likely to be used under monthly than 
under weekly payments. Where this book-credit habit or 
habit of " charging " is prevalent, the great bulk of money 
is spent on pay day. It is probable that the substitution of 
weekly for monthly payments, when it has taken place, has 
enabled many workingmen, who formerly found it necessary 
to trade on credit, to make their own payments in cash, thus 
decreasing the velocity of turnover of money. 

Frequency of disbursements evidently has an effect simi- 
lar to the effect of frequency of receipts ; i.e. it tends to 
accelerate the velocity of turnover, or circulation. 

2. (6) Regularity of payment also facilitates the turn- 
over. When the workingman can be fairly certain of both 
his receipts and expenditures, he can, by close calculation, 
adjust them so precisely as safely to end each payment cycle 
with an empty pocket. This habit is extremely common 
among certain classes of city laborers. On the other hand, 
if the receipts and expenditures are irregular, either in 
amount or in time, prudence requires the worker to keep a 
larger sum on hand to insure against mishaps. Even when 
foreknown with certainty, irregular receipts require a larger 
average sum to be kept on hand. We may therefore con- 
clude that regularity of receipts and of payments tends to 
increase velocity of circulation. 

2. (c) Next, consider the synchronizing of receipts and 
disbursements, i.e. making payments at the same intervals 
as obtaining receipts. It is manifestly a great convenience 
to the spender of money or of deposits, if dealers to whom 



IQO ELEMENTS OF ECONOMIC SCIENCE 

he is in debt will allow him to postpone payment until he has 
received his money or his check. This arrangement obvi- 
ates the necessity of keeping much money or deposits on 
hand, and therefore increases their velocity of circulation. 
Where payments such as rent, interest, insurance, and taxes, 
occur at periods irrespective of the times of receipts of money, 
it is often necessary to accumulate money or deposits in 
advance, thus increasing the average on hand, withdrawing 
money from use for a time, and decreasing the velocity of 
circulation. 

We conclude, then, that synchronizing and regularity of 
payment, no less than frequency of payment, have tended 
to increase prices by an increasing velocity of circulation. 
The change from monthly to weekly payments of workmen 
has been progressing rapidly, and in many states has been 
made mandatory by law. So far as these factors have oper- 
ated, therefore, there has been a tendency for prices to rise. 

§ 5. Influence of General Causes on Velocities of Circu- 
lation and Indirectly on Price Levels 

3. {a) The more densely populated a locality, the more 
rapid will be the velocity of circulation, because there will be 
readier access to people from whom money is received or to 
whom it is paid. In the country, although there are no 
statistics, the velocity of circulation must be much slower 
than in the city. A lady who has a city house and a country 
house states that in the country she keeps money in her 
purse for weeks, whereas in the city she keeps it but a few 
days. Pierre des Essars has worked out the velocity of cir- 
culation at banks in many European cities. Examination 
of his figures reveals the fact that in almost all cases the 
larger the town in which the bank is situated, the more active 
the deposits. 

3. {h) Again, the more extensive and the speedier the 
transportation facilities, in general the more rapid the circu- 



INFLUENCES OUTSIDE THE EQUATION 191 

lation of money. Anything which makes it easier to pass 
money from one person to another will tend to increase the 
velocity of circulation. Railways have this effect. The 
telegraph has increased the velocity of circulation of de- 
posits, since these can now be transferred thousands of miles 
in a few minutes. Mail and express, by facilitating the 
transmission of bank deposits and money, have likewise 
tended to increase their velocity of circulation. 

We conclude, then, that density of population and rapidity 
of transportation have tended to increase prices by increas- 
ing velocities. 

§ 7. Influences on the Volume of Deposit Currency and 
therefore on Prices 

We have to consider lastly the specific outside influences 
on the volume of deposits subject to check. 

These are chiefly : — 

(i) The system of banking and the habits of the people in 
utilizing that system. 

(2) The habit of " charging." 

(i) It goes without saying that a banking system must 
be devised and developed before it can be used. The in- 
vention of banking has made deposit currency possible, and 
its adoption has undoubtedly led to a great rise of prices. 

(2) *' Charging " is often a preliminary to payment by 
check rather than by cash. If a customer did not have his 
obHgations " charged," he would pay in money and not by 
check. The ultimate effect of this practice, therefore, is to 
increase the ratio of check payments to cash payments and 
the ratio of deposits to money carried, therefore to increase 
the amount of credit currency which a given quantity of 
money can sustain. This effect, the substitution of checks 
for cash payments, is probably by far the most important 
effect of " charging," and exerts a powerful influence toward 
raising prices. 



CHAPTER XII 

OUTSIDE INFLUENCES CONTINUED 

§ I. Influence of " The Balance of Trade " on the 
Quantity of Money 

We have now considered those influences outside the 
equation of exchange which affect the volume of trade 
(the (J's), the velocities of circulation of money and deposits 
(F and V'), and the amount of deposits (M'). We have 
reserved for separate treatment in this chapter the outside 
influences that affect the quantity of money (M) . 

The chief of these may be classified as follows : — 

1. Influences operating through the exportation and im- 

portation of money. 

2. Influences operating through the melting or minting 

of money. 

3. Influences operating through the production and con- 

sumption of money metals. 

4. Influences produced by prevaiHng monetary and bank- 

ing systems. 
I. The first to be considered is the influence of foreign 
trade. Hitherto we have confined our studies of price level 
to an isolated community, having no trade relations with 
other communities. In the modern world, however, no 
such community exists, and it is important to observe that 
international trade gives present-day problems of money and 
of the price level an international character. If all coun- 
tries had their own irredeemable paper money, and no money 
that was acceptable elsewhere, there could be no interna- 
tional adjustment of monetary matters. Price levels in 
different countries would have no intimate connection. 

192 



OUTSIDE INFLUENCES 1 93 

Indeed, to some extent the connection is actually broken 
between existing countries which have different metallic 
standards, — for example, between a gold-basis and a 
silver-basis country, — although through their non-monetary 
uses the two metals are still somewhat bound together, 
as any two substitutes, or partial substitutes, are bound 
together. But where two or more nations trading with 
each other use the same standard, there is a tendency for 
the price levels of each to influence profoundly the price 
levels of the other. 

The price level in Switzerland depends largely upon the 
price level in other countries. Gold, which is the basic or 
full weight money in most civiKzed nations, is constantly 
traveHng from one country or community to another. 
When a single small country is under consideration, it is 
therefore preferable to say that the quantity of money in 
that country is determined by the universal price level, 
rather than to say that its level of prices is determined by 
the quantity of money within its borders. An individual 
country bears the same relation to the world that a lagoon 
bears to the ocean. The level of the ocean depends, of 
course, upon the quantity of water in it. But when we 
speak of the lagoon we reverse the statement, and say 
that the quantity of water in it depends upon the level 
of the ocean. As the tide in the outside ocean rises and 
falls, the quantity of water in the lagoon will adjust itself 
accordingly. 

To simphfy the problem of the distribution of money 
among different communities, we shall, for the time being, 
ignore the fact that money consists ordinarily of material 
capable of non-monetary uses. We shall Hkewise, for the 
present, omit consideration of the production of money 
through mining. 

Let us, then, consider the causes that determine the quan- 
tity of money in a state like Connecticut. If the level of 
prices in Connecticut temporarily falls below that of 



194 ELEMENTS OF ECONOMIC SCIENCE 

the surrounding states, Rhode Island, Massachusetts, 
and New York, the effect is to cause an export of money 
from these states to Connecticut, because people will 
buy goods wherever they are cheapest and sell them 
wherever they are dearest. With its low prices, Connec- 
ticut becomes a good place to buy from, but a poor 
place to sell to. But if outsiders buy of Connecticut, they 
will have to bring money to buy vnth. There will, there- 
fore, be a tendency for money to flow to Connecticut until 
the level of prices there rises to a level which will arrest the 
influx. If, on the other hand, prices in Connecticut are 
higher than in surrounding states, it becomes a good place 
to sell to and a poor one to buy from. But if outsiders sell 
to Connecticut, they will receive money in exchange. There 
is then a tendency for money to flow out of Connecticut 
until the level of prices in Connecticut is lower. In general, 
money flows away from places where the level of prices is 
high, and towards places where it is low. Men sell goods 
where they can get most money, and buy goods where they 
will have to give least money. We say " money," for in 
the long run we do not need to consider the interflow of any 
other currency than money ; as we have seen, in the long 
run deposit currency will maintain a definite ratio to money. 
But it must not be inferred that the prices of various arti- 
cles, or even the general level of prices, will become precisely 
the same in all countries. Distance, ignorance as to where 
the best markets are to be found, tariffs, and costs of trans- 
portation, help to maintain price differences. The native 
products of each region tend to be cheaper in that region. 
They are exported as long as the excess of prices abroad 
is enough to more than cover the cost of transportation. 
Practically a commodity will not be exported at a price 
which will not at least be equal to the price in the 
country of origin, plus the freight. Many commodities 
are shipped only one way. Thus, wheat is shipped from 
the United States to England, but not from England to the 



OUTSIDE INFLUENCES 1 95 

United States. It is produced in the United States, and 
tends to be cheaper here. Large exportations raise its price 
in America toward the price in England, but it will usually 
keep below that price by the cost of transportation. Other 
commodities that are cheap to transport will be sent in 
either direction, according to market conditions. 

But, although international and interlocal trade will 
never bring about exact uniformity of price levels, it will 
produce an adjustment of these levels toward uniformity by 
regulating, in the manner already described, the distribu- 
tion of money. If one commodity enters into international 
trade, it will suffice to act as a regulator of money dis- 
tribution ; for, in return for that commodity, money may 
flow, and as the price level rises or falls, the quantity of that 
commodity sold may be correspondingly adjusted. In or- 
dinary intercourse between nations, even when a deliberate 
attempt is made to interfere with it by protective tariffs, 
there will always be a large number of commodities thus 
acting as outlets and inlets. And since the quantity of 
money itself affects prices for all sorts of commodities, the 
regulative effect of international trade applies not simply 
to the commodities which enter into that trade, but to all. 
It follows that nowadays international and interlocal 
trade is constantly regulating price levels throughout the 
world. 

We must not leave this subject without emphasizing the 
effects of a tariff on the purchasing power of money. When 
a country adopts a tariff, the tendency is for the level of 
prices to rise. A tariff obviously raises the prices of the 
'^ protected " goods. But it does more than that — it tends 
also to raise the prices of w/^protected goods. Thus, the 
tariff first causes a decrease in imports. Though in the 
long run this decrease in imports will lead to a correspond- 
ing decrease in exports, yet at first there will be no such 
adjustment. The foreigner will, for a time, continue to 
buy from the protected country almost as much as before. 



196 ELEMENTS OE ECONOMIC ' SCIENCE 

This will result temporarily in an excess of that country's 
exports over its imports, or a so-called " favorable " bal- 
ance of trade, and a consequent inflow of money. This 
inflow will eventually raise the prices not alone of pro- 
tected goods but of unprotected goods as well. The rise 
will continue till it reaches a point high enough to put a 
stop to the " favorable " balance of trade. 

Although the " favorable balance " of trade created by a 
tariff is temporary, it leaves behind a permanent increase of 
money and of prices. 

This is perhaps the chief reason why a protective tariff 
seems to many a cause of prosperity. It furnishes a tempor- 
ary stimulus not only to protected industries but to trade in 
general, which is really simply a stimulus of money inflation. 

Our present interest in international trade, however, is 
mainly directed to its effects on international price levels. 
Except for the export or import of money to adjust the 
price levels, international trade is at bottom merely an 
interchange of goods. The " goods " entering into inter- 
national trade include not only the visible exports and im- 
ports, but also securities, services of carrying vessels con- 
ducting the trade, and in fact any wealth, property, or serv- 
ices exchanged. 

We have shown how the international and interlocal equi- 
librium of prices may be disturbed by differential changes 
only in the quantity of money. But it may be disturbed 
by differential changes also in the volume of bank deposits ; 
or in the velocity of circulation of money ; or in the veloc- 
ity of circulation of bank deposits; or in the volume of 
trade. And whatever may be the source of the difference 
in price levels, equilibrium will eventually be restored 
through an international or interlocal redistribution of 
money and goods brought about by international and inter- 
local trade. Other elements in the equation of exchange 
than money and commodities can not be transported from 
one place to another. 



OUTSIDE INTLUENCES 1 97 

§ 2. Influence of melting and minting on the Quantity 

of Money 

We have seen how M in the equation of exchange is 
affected by the import or export of money. Considered 
with reference to the M in any one of them, the M^s in all 
the others are " outside influences." 

Proceeding now one step farther, we must consider those 
influences on M that are not only outside of any equation of 
exchange for a particular country but outside those for the 
whole world. Besides the monetary inflow and outflow 
through import and export, there is an inflow and outflow 
through minting and melting. In other words, not only 
do the stocks of money in the world connect with each other 
like interconnecting bodies of water, but they connect in 
the same way with the outside stock of bullion. In the 
modern world one of the precious metals, — such as gold 
or silver, — usually plays the part of primary money, and 
this metal has two uses, — a monetary use and a commodity 
use. That is to say, gold or silver is not only a money- 
material but a commodity as well. In their character of 
commodities, the precious metals are raw materials for 
jewelry, works of art, and other products into which they 
may be wrought. It is in this unmanufactured or raw state 
that they are called bullion. Now gold money, for example, 
may be changed into gold bullion, and vice versa. In fact, 
both changes are going on constantly, for if the value of 
gold as compared with other commodities is greater in the 
one use than in the other, gold will immediately flow toward 
whichever use is more profitable, and the market price of 
gold bullion will determine the direction of the flow. Since 
loo ounces of gold, jq fine, can be transformed into $1860, 
the market value of so much gold bullion, yu fine, must 
tend to be $1860. If it costs nothing to have bullion coined 
into money, and nothing to melt money into bullion, there 
will be an automatic flux and reflux from money to bullion 



igS ELEMENTS OF ECONOMIC SCIENCE 

and from bullion to money that will prevent the price of 
bullion from varying greatly. On the one hand, if the price 
of gold bullion is greater than the money which could be 
minted from it, no matter how sHght the difference may 
be, the users of gold who require bulKon — notably jewel- 
ers — will save this difference by melting gold coin into 
bullion. Contrariwise, if the price of bullion is less than 
the value of gold coin, the owners of bulKon will save the 
difference by taking bulKon to the mint and having it 
coined into gold dollars, instead of selling it in the bulHon 
market. The effect of melting coin, on the one hand, is to 
decrease the amount of gold money and increase the amount 
of gold bullion, thereby lowering the value of gold as bul- 
Kon and raising the value of gold as money; thereby 
lowering the price level and restoring the equahty between 
bullion and money. The effect of minting bulHon into coin 
is by the opposite process to bring the value of gold as coin 
and the value of gold as bulhon again into equihbrium. 

Where a charge — called seigniorage — is made for 
changing bullion into coin, or where the process involves 
expense or delay, the flow of bullion into currency will be, to 
that extent, impeded. But under a modern system of free 
coinage and with modern methods of metallurgy, both melt- 
ing and minting may be performed so inexpensively and so 
quickly that there is practically no cost and no delay in- 
volved. In fact, there are few instances of more exact 
price adjustment than the adjustment between gold buUion 
and gold coin. It follows that the quantity of money, and 
therefore its purchasing power, is directly dependent on 
that of gold bullion. 

This stabihty of the price of gold bullion expressed 
in gold coin causes confusion in the minds of people, 
giving them the erroneous impression that there is no 
change in the value of money. Indeed, this stabihty has 
often been cited to show that gold is a stable standard of 
value. Dealers in objects made of gold seem to misunder- 



OUTSIDE INFLUENCES 1 99 

stand the significance of the fact that an ounce of gold 
always costs about $18.60 in the United States or £3, 175., 
and 102 d. in England. This means nothing more than 
the fact that gold in one form and measured in one way will 
always bear a constant ratio to gold in another form and 
measured in another way. An ounce of gold bullion is 
worth a fixed number of gold dollars, for the same reason 
that a pound sterHng of gold is worth a fixed number of 
dollars, or that a gold eagle is worth a fixed number of 
dollars. 

Except, then, for extremely slight and temporary fluc- 
tuations, gold bulHon and gold money must always have the 
same value. Therefore in the following discussion respect- 
ing the more considerable fluctuations affecting both, we 
shall speak of both interchangeably as " the value of gold." 

§ 3. Influence of the Production and Consumption of 
Money Metals on the Quantity of Money 

The stock of bullion is not the ultimate outside influence 
on the quantity of money. As the stock of bullion and the 
stock of money influence each other, so the total stock of 
both is itself influenced by production and consumption. 
The production of gold consists of the output of the mines — 
which constantly tends to add to the existing stocks both 
of bulUon and coin. The consumption of gold consists of 
the use of bullion in the arts by being wrought up into 
jewelry, gilding, etc., and of losses by abrasion, shipwreck, 
etc. If we consider the amount of gold coin and bullion as 
a reservoir, production would be the inflow (from the mines) , 
and consumption the outflow to the arts and by destruction 
and loss. To the inflow from the mines should be added the 
re-inflow from forms of art into which gold had previously 
been wrought but which have grown obsolete, illustrated 
by the business of producing gold bulhon by burning old 
picture frames. 



200 ELEMENTS OF ECONOMIC SCIENCE 

We shall consider first the inflow or production, and after- 
ward the outflow or consumption. The regulator of the 
inflow (which practically means the production of gold 
from the mines) is its estimated cost of production. Where- 
ever the estimated cost of producing a dollar of gold is less 
than the existing value of a dollar in gold, it will normally 
be produced. Wherever the cost of production exceeds the 
existing value of a dollar, gold Vvdll normally not be pro- 
duced. In the former case the production of gold is profit- 
able ; in the latter it is unprofitable. 

This holds true, in whatever way cost of production is 
measured — whether in terms of gold itself, or in terms of 
some other commodity such as wheat, or of commodities in 
general, or of any supposed " absolute " standard of value. 
In gold-standard countries gold miners do actually reckon 
the cost of producing gold in terms of gold. From their 
standpoint it is a needless complication to translate the 
cost of production and the value of the product into some 
other standard than gold. They are interested in the re- 
lation between the two, and this relation wiU not be affected 
by the standard. 

To illustrate how the producer |of gold measures every- 
thing in gold, suppose that the price level rises. He will then 
have to pay more dollars for wages, machinery, fuel, etc., 
while the prices obtained for his product (expressed in those 
same dollars) will, as always, remain unchanged. Con- 
versely, a fall in the price level will lower his cost of pro- 
duction (measured in dollars), while the price of his product 
will still remain the same. Thus we have a constant number 
expressing the price of gold product and a variable number 
expressing its cost of production. If we express the same 
phenomena, not in terms of gold but in terms of wheat, or 
rather, let us say, in term^s of goods in general, we shall 
have the opposite conditions. 

Of course the comparison is the same, whether we use 
gold or other commodities as our criterion. In the one 



OUTSIDE INFLUENCES 20I 

view, a rise of prices means a rise in the gold miner's cost 
of production ; in the other it means a fall in the price 
(purchasing power) of his product. In either view he 
will be discouraged. He will look at his troubles in the 
former light, i.e. as a rise in the cost of production ; but we 
shall find it more useful to look at them in the latter, i.e. as 
a fall in the purchasing power of the product. The cost of 
production in either case is compared with the purchasing 
power of gold. If this purchasing power is above the cost 
of production in any mine, it will pay to work that mine. 
If the purchasing power of gold is lower than the cost of 
production of any mine, it will not pay to work that mine. 
Thus the production of gold increases or decreases with an 
increase or decrease in the purchasing power of money. 

So much for the inflow of gold and the conditions regu- 
lating it. We turn next to outflow or consumption of gold. 
This has two aspects, viz. consumption in the arts and con- 
sumption for monetary purposes. 

If objects made of gold are cheap, — that is, if the prices 
of other things are relatively high, — then the relative 
cheapness of the gold objects will lead to an increase in 
their use. Or, expressing the matter in terms of money 
prices, when people find prices of everything else higher and 
their own incomes likewise higher, while gold watches and 
gold ornaments generally remain at their old level, they can 
afford to buy more gold watches and ornaments. 

These are instances of the consumption of gold in the 
form of commodities. The consumption of gold as coin is 
a matter of abrasion, of waste and wear. It changes with 
the changes in the amount of gold in use and in its rapidity 
of exchange. The important result is that an increase in 
the price (purchasing power) of a gold dollar encourages 
the production of gold and discourages its consumption 
just as an increase in the price of any other commodity 
encourages its production and discourages its consumption. 
A decrease, of course, acts in the opposite way. The pur- 



202 



ELEMENTS OF ECONOMIC SCIENCE 



chasing power of money, being thus played upon by the 
opposing forces of production and consumption, is driven 
up or down as the case may be. 

§ 4. Mechanical Illustration of these Influences 

In any complete picture of the forces determining the 
purchasing power of money we need to keep prominently 
in view three groups of factors: (i) the production or the 
" inflow " of gold (i.e. from the mines) ; (2) the consump- 
tion or " outflow " (into the arts and by destruction and 
loss) ; and (3) the " stock " or reservoir of gold (whether 
coin or bullion) which receives the inflow and suffers the 
outflow. The relations among these three sets of magni- 




FiG. 10. 

tudes can be set forth by means of a mechanical illustration, 
given in Figure 10. This represents two connected reser- 
voirs of water, Gj, and G^. The contents of the first reser- 
voir represent the stock of gold bullion, and the contents 
of the second the stock of gold money. Since purchasing 
power increases with scarcity, the distance from the top of 
the cisterns, 00 to the surface of the liquid is taken to 
represent the purchasing power of gold over other goods. 
A lowering of the level of the liquid in G^ indicates an in- 



OUTSIDE INFLUENCES 203 

crease in the purchasing power of money, since we measure 
this purchasing power downward from the hne 00 to the 
surface of the liquid. We shall not attempt to represent 
other forms of currency explicitly in the diagram. We have 
seen that normally the quantities of other currency are 
proportional to the quantity of primary money, which we 
are supposing to be gold. Therefore the variation in the 
purchasing power of this primary money may be taken as 
representative of the variation of all the currency. We 
shall now explain the shapes of these cisterns. The shape 
of the cistern G^ must be such as will make the distance of 
the liquid surface below 00 decrease with an increase of 
the liquid, in exactly the same way as the purchasing power 
of gold decreases with an increase in its quantity. That is, 
as the quantity of liquid in G^ doubles, the distance of the 
surface from the line 00 should decrease by one half. In 
the same way for gold bullion, the shape of the cistern must 
be such as will make the distance of the liquid surface below 
00 decrease with an increase of the liquid in the same way 
as the value of gold bullion decreases with the stock of gold 
bullion. The shapes of the two cisterns need not, and 
ordinarily will not, be the same. 

Both reservoirs have inlets and outlets. Let us con- 
sider these in connection with the bullion reservoir (Gj). 
Here each inlet represents a particular mine supplying bul- 
lion, and each outlet represents a particular use in the arts 
consuming gold bulhon. Each mine and each use has its 
own distance from 00. There are, therefore, three sets 
of distance from 00 : the inlet distances, the liquid surface 
distance, and the outlet distances. Each inlet distance 
represents the cost of production, measured in goods for 
each mine ; each outlet distance represents the value of 
gold in each particular use in goods. The surface distance, 
as we have already explained, represents the value of bul- 
lion, likewise measured in goods, — in other words, its pur- 
chasing power. 



204 ELEMENTS OF ECONOMIC SCIENCE 

It is evident that among these three sets of levels there 
will be' discrepancies. These discrepancies serve to interpret 
the relative state of things as among mines, bullion, and 
uses of gold at any given moment, and will determine the 
various flows — in and out. If an inlet at a given mo- 
ment be above the surface-level, i.e. at a less distance 
from 00, the interpretation is that the cost of produc- 
tion is less than the purchasing power of the bullion. 
Hence the mine owner will turn on his spigot and keep it 
on until, perchance, the surface-level rises to the level of his 
mine, — i.e. until the surface-distance from 00 is as small 
as the inlet-distance — i.e. until the purchasing power of bul- 
lion is as small as the cost of production. At this point there 
is no longer any profit in mining. So much for inlets ; now 
let us consider outlets. If an outlet at a given moment be 
below the surface-level, — i.e. at a greater distance from 00, — 
the interpretation is that the value of gold in that par- 
ticular use is greater than the purchasing power of bullion. 
Hence gold bulHon will flow into these uses where its worth 
is greater than as bullion. That is, it will flow out of all 
outlets below the surface in the reservoir. 

It is evident, therefore, that at any given moment, only 
the inlets above the surface-level, and only the outlets below 
it, will be called into operation. As the surface rises, there- 
fore, more outlets will be brought into use, but fewer inlets. 
That is to say, the less the purchasing power of gold as 
bullion, the more it will be used in the arts, but the less 
profitable it will be for the mines to produce it, and the 
smaller will be the output of the mines. As the surface 
falls, more inlets will come into use and fewer outlets. 

We turn now to the money reservoir (G^). The outlets 
from this reservoir represent the consumption of gold coins 
by loss and abrasion. These increase with increase of the 
stock of coins. The fact that gold has the same value 
either as bullion or as coin, because of the interflow between 
them, is interpreted in the diagram by connecting the 



OUTSIDE INFLUENCES 205 

bullion and coin reservoirs, in consequence of which both 
will (like water) have the same level. The surface of the 
liquid will in both cases be the same distance below the line 
00, and this distance represents the value of gold. Should 
the inflow at any time exceed the outflow, the result will 
necessarily be an increase in the stock of gold in existence. 
This will tend to decrease the purchasing power or value 
of gold. But as soon as the surface rises, fewer inlets and 
more outlets will operate. That is, the excessive inflow 
on the one hand will decrease, and the deficient outflow 
or consumption on the other hand will increase, checking 
the inequality between the outflow and inflow. If, on the 
other hand, the outflow should temporarily be greater than 
the inflow^, the reservoir will tend to become less full. The 
purchasing power will increase ; thus the excessive outflow 
will be checked, and the deficient inflow stimulated, — 
restoring equilibrium. The exact point of equilibrium mxay 
seldom or never be realized, but as in the case of a pendu- 
lum swinging back and forth through a position of equi- 
librium, there will always be a tendency to seek it. 

It need scarcely be said that our mechanical diagram is 
intended merely to give a picture of some of the chief vari- 
ables involved in the problem under discussion. It does 
not of itself constitute an argument, or add any new ele- 
ment ; nor should one pretend that it includes explicitly all 
the factors which need to be considered. But it does enable 
us to grasp the chief factors involved in determining the 
purchasing power of money. It enables us to observe and 
trace the following important variations and their effects : — 

First, if there be an increased production of gold or im- 
proved methods of working old ones, — due, let us sup- 
pose, to the discovery of new mines, — this may be 
represented by an increase in the number or size of the 
inlets into the Gj reservoir ; the result will evidently be an 
increase of '' inflow " into *the bullion reservoir, and from 
that into the currency reservoir, a consequent gradual fill- 



206 ELEMENTS OF ECONOMIC SCIENCE 

ing up of both, and therefore a decrease in the purchasing 
power of money. This process will be checked finally by 
the increase in consumption. And when production and 
consumption become equal, an equilibrium will be estab- 
Ushed. An exhaustion of gold mines obviously would 
operate in exactly the reverse manner. 

Secondly, if there be an increase in the consumption of 
gold, — as through some change of fashion, — it may be 
represented by an increase in the number or size of the out- 
lets of Gb. The result will be a draining out of the bullion 
reservoir, and consequently a decreased amount in the 
currency reservoir; hence an increase in the purchasing 
power of gold, which increase will be checked finally by an 
increase in the output of the mines as well as by a 
decrease in consumption. When the increased production 
and the decreased consumption become equal, equilibrium 
will again be reached. 

If the connection between the currency reservoir and the 
bullion reservoir is closed by a valve so that gold cannot flow 
from bulHon into money (although it can flow in the reverse 
direction), then the purchasing power of the gold as money 
may become greater than its value as bullion. Whatever 
increase may take place in the production of gold will then 
tend only to fill the bullion reservoir and decrease the dis- 
tance of the surface from the line 00, i.e. lower the value 
of gold bullion. The surface of the liquid in the money 
reservoir will not be brought nearer 00. It may even be 
lowered farther away. In other words, the purchasing 
power of money will be entirely independent of the value 
of the bullion out of which it was first made. 

We have now discussed all but one of the outside influ- 
ences upon the equation of exchange. That one is the 
character of the monetary and banking system which affects 
the quantity of money and deposits. This we reserve for 
special discussion in the following two chapters. Mean- 
while we may here summarize such of those influences dis- 



OUTSIDE INFLUENCES 207 

cussed in this and the preceding chapter as operate in more 
than one way. Consider, for instance, technical knowledge 
and invention, which affect the equation of exchange by in- 
creasing trade. So far as these increase trade, the tendency 
is to decrease prices ; but so far as they develop metallurgy 
and the other arts tending to increase the production and 
easy transportation of the precious metals, they tend to in- 
crease prices. So far as they make the transportation and 
transfer of money and deposits quicker, they also tend to 
increase prices. So far as they lead to the development of 
the art of banking, they likewise tend to increase prices, both 
by increasing deposit currency {M') and by increasing the 
velocity of circulation both of money and deposits. So 
far as they lead to the concentration of population in cities, 
they tend to increase prices by accelerating circulation. 

Finally, so far as per capita trade is increased through 
this or any other cause, there is a tendency to increase the 
velocity of circulation of money. What the net effect may 
be during any given period will depend on the predominant 
direction in which the arts are developed. 

It is also noteworthy that almost all of the influences 
affecting either the quantity or the velocities of circulation 
have been and are predominantly in the direction of higher 
prices. Almost the only opposing influence is the increased 
volume of trade ; but this is largely neutralized by increased 
velocities due to the increased trade itself, and by the pro- 
gressive increase and concentration of population, which 
helped to bring about the increase of trade. 



CHAPTER XIII 

OPERATION OF MONETARY SYSTEMS 

§ I. Gresham's Law 

Thus far we have considered the influences that deter- 
mine the purchasing power of money when the money in 
circulation is all of one kind. The illustration given in the 
previous chapter shows how the money mechanism operates 
when a single metal is used as the primary money and is 
freely minted and melted. We ^ have now to consider the 
monetary systems in which more than one metal enjoys this 
status, beginning with the most familiar system, — that of 
bimetallism. 

One of the first difficulties in the early history of money 
was that of keeping two (or more) metals in circulation. 
One of the two would become cheaper than the other, and 
the cheaper would drive out the dearer. 

To this tendency has been given the name of " Gresham's 
Law " in honor of Sir Thomas Gresham, a financial adviser 
of Queen Elizabeth of England. It was he who propounded 
it in the middle of the sixteenth century. But the law 
seems to have been recognized among the ancient Greeks. 
It is mentioned in the " Frogs " of Aristophanes : — 

*' For your old and standard pieces, valued and approved and 
tried, 
Here among the Giecian nations and in all the world beside 
Recognized in every realm for trusty stamp and pure assay, 
Are rejected and abandoned for the trash of yesterday ; 
For a vile, adulterate issue, drossy, counterfeit and base 
Which the traffic of the City passes current in their place ! " 

Gresham's Law is ordinarily stated in the form, "Bad 
money drives out good money," for it was usually observed 

208 



OPERATION OF MONETARY SYSTEMS 209 

that the badly worn, defaced, Hght-weight, " clipped," 
" sweated," and otherwise deteriorated money tended to 
drive out the full-weight, freshly minted coins. This formu- 
lation, however, is not accurate. It is not true that '' had " 
coins, e.g. worn, bent, defaced, or even clipped coins will 
drive out other money just because of their worn, bent, 
defaced, or clipped condition. Accurately stated, the law 
is simply this : Cheap money will drive out dear money. The 
reason why, of two moneys, the cheaper always prevails, is 
that the choice of the use of money rests chiefly with the 
man who gives it in exchange, not with the man who re- 
ceives it. When any one has the choice of paying his debts 
in either of two moneys, motives of economy will prompt 
him to use the cheaper. .If the initiative and choice lay 
principally with the person who receives instead of the per- 
son who pays the money, the opposite would hold true. The 
dearer or " good " money would then drive out the cheaper 
or " bad " money. It is because the debtor exercises the 
choice that the cheaper money tends to continue in circu- 
lation. What becomes of the dearer money? It may be 
hoarded, or go into the melting pot, or go abroad — hoarded 
and melted from motives of economy, and sent abroad be- 
cause, where foreign trade is involved, it is the foreigner who 
receives the money rather than ourselves who give it that 
dictates what kind of money shall be accepted. He will 
take only the best, because our legal-tender laws do not 
bind him. 

Gresham's Law applies not only to two rival moneys of 
the same metal — it apphes to all moneys that circulate 
concurrently. Until '' milUng " the edges of coins was 
invented, and a ^' limit of tolerance " of the mint (deviation 
from the standard weight) was adopted, much embarrass- 
ment was felt in commerce from the fact that the clipping 
and debasing ofj coin was a common practice. Nowadays, 
however, any coin which has been so '' sweated " or clipped 
as to reduce its weight appreciably ceases to be legal tender, 



2IO ' ELEMENTS OF ECONOMIC SCIENCE 

and being commonly rejected by those to whom it is offered, 
ceases to be money. Within the customary or legal limits 
of tolerance, however, — that is, as long as the cheaper 
money retains the " money " power, — it will still drive 
out the dearer. 

§ 2. When Bimetallism Fails 

The obvious effect of Gresham's Law is to decrease the 
purchasing power of money at every opportunity. The 
history of the world's currencies is largely a record of money 
debasements, often at the behest of the sovereign. Our 
chief purpose now, in considering Gresham's Law, is to 
formulate more fully the causes determining the purchasing 
power of money under monetary systems subject to the 
operation of Gresham's Law. The first application is to 
bimetallism. 

In order to understand fully the influence of any monetary 
system on the purchasing power of money, we must first 
understand how the system works. It has been denied that 
bimetallism ever did work or can be made to work, because 
the cheaper metal will drive out the dearer. Our first task 
is to show, quite irrespective of its desirability, that bi- 
metallism can and -does "work" under certain circum- 
stances, but not under others. To make clear when it will 
work and when it will not work, we shall continue to em- 
ploy the mechanical illustration of the last chapter, in 
which the amount of gold bullion is represented by the con- 
tents of reservoir Gj (Figs, ii, 12). Here, as before, we 
represent the purchasing power or value of gold by the dis- 
tance of the water level below the zero level 00. Now, in 
the last chapter, our figure represented only one metal, gold, 
and represented that metal in two reservoirs — the bullion 
reservoir and the coin reservoir. We shall now, a step at a 
time, elaborate that figure. First, as in Figure 1 1 a, we add 
a reservoir for silver bullion (5j), a reservoir of somewhat 



OPERATION or MONETARY SYSTEMS 211 

different shape and size from G^. This reservoir might be 
used to show the relation between the value or purchasing 
power of silver and its quantity in the arts and as bullion. 
Here, then, are three reservoirs. At first the silver one is 
entirely isolated; but after a while we shall connect it 
with the middle one. For the present let us suppose that 
the middle one, which contains money, is entirely filled with 
gold money only (Fig. iia), no silver being yet used as 
money. In other words, the monetary system is the same 
as that discussed in the last chapter. The only change we 
have introduced is to add to the picture another reservoir 
{Si)y entirely detached, showing the quantity and value of 
silver bullion. 

We next suppose a pipe opened at the right, connecting 
5j with the money reservoir, that is, we introduce bimet- 
allism. Under bimetallism, governments open their mints 
to the free coinage of both metals at a fixed ratio, i.e. a fixed 
ratio between the said metals. For instance, if a silver 
dollar contains i6 grains of silver for every grain of gold 
in a gold dollar, the ratio is said to be 1 6 to i. Under this 
system, the debtor has the option, unless otherwise bound 
by his contract, of making payment either in gold or in 
silver money. These, in fact, are the two requisites of 
complete bimetallism, viz. : (i) the free and unlimited 
coinage of both metals at a fixed ratio, and (2) the un- 
limited legal tender of each metal at that ratio. These new 
conditions are represented in Figure iih (and later. Fig. 1 2 ft) , 
where a pipe gives silver an opening into the money or cen- 
tral reservoir. 

VvThat we are about to represent is not the relations be- 
tween mines, bullion, and arts, but the relations between 
bullion (two kinds) and coins. We may therefore disre- 
gard for the present all inlets and outlets except the con- 
nections between the bullion reservoirs and coin reservoir. 

Now in these reservoirs the surface-distances below 00 
represent, as we have said, purchasing power. Purchasing 



212 



ELEMENTS OF ECONOMIC SCIENCE 



power of what ? Of gold and of silver, yes ; but each unit 
of silver (say each drop of silver water, whether as money 
or as bullion) contains i6 times as many grains as each unit 
of gold (say drop of gold water, whether as money or as 
bullion). We all know, of course, that a silver dollar is 
much larger than a gold dollar. But for the sake of our 




Fig. II. 



mechanical representation we may disregard this differ- 
ence, and regard a drop of gold (whether money or bullion) 
as occupying equal space with a drop of silver (money or 
bullion). That is, a unit of water represents a dollar of 
gold or a dollar of silver. All we wish to represent is the 
relative purchasing power of corresponding units. 

The waters representing gold and silver money are sepa- 
rated by a movable film f. In Figure ii a this film is at 



OPERATION OF MONETARY SYSTEMS 213 

the extreme right, in Figure 1 1 i>, at the extreme left, in Fig- 
ure 12 a, again at the right, and in Figure 126, midway. The 
a figures represent conditions before the mints are opened 
to silver- The b figures represent conditions after they 
have been opened and Gresham's law has operated. If, 
just previous to the introduction of bimetallism, the silver 
level is below the gold level, the statute introducing bi- 
metallism will be inoperative, i.e. the silver bullion will not 
flow into the money reservoir ; but if, as in Figure 1 1 a or 1 2 a 
the silver level is higher, then as soon as the mints are open 
to silver, it will flow into circulation. Being at first cheaper 
than gold, it will push out the gold. This expulsion of gold 
may be complete, as shown in Figure 11 b, or only partial, 
as shown in Figure 12 b. The expulsion will continue just 
as long as there is a premium on gold ; that is, as long as 
the silver level in the bullion reservoir is above the gold 
level in the money reservoir ; i.e. as long as silver bullion 
is cheaper than gold money. 

Let mm, as shown in Figure 11 a, be the mean level ; 
that is, a level such that the volume x above it equals the 
combined vacant volumes y and z below it. This line mm 
remains the mean level, whatever may be the distribution 
of the contents among the three reservoirs. As soon as 
the connecting pipe is inserted, silver will flow into the 
money reservoir and, in accordance with Gresham's Law, 
will displace gold. 

Here we have to distinguish two cases : (i) when the sil- 
ver X above the mean line mm exceeds the contents of the 
money reservoir below this line; (2) when x is less than said 
lower contents. In the first case, it is evident that silver will 
sweep gold wholly out of circulation, as shown in Figure 116 
where the film Jff has moved from the extreme right to the 
extreme left. The contents of silver in the bullion reser- 
voir are less than before, and the contents of gold in the 
bullion reservoir greater than before. 

But this redistribution is only the first effect of opening 



214 ELEMENTS OE ECONOMIC SCIENCE 

the mints to silver. The balance between production and 
consumption has been upset both for gold and for silver. 
The increased value of silver (lowered level in Sj,) has 
stimulated production, bringing into operation silver mines 
(uncovered inlets at right) ; and, on the other hand, the 
decreased value of gold (raised level in G^) has discouraged 
gold production, shutting off gold mines (covered inlets at 
left). Like alterations are effected in the outflows, i.e. 
the consumption, waste, and absorption of each metal. 
The result is that the levels resulting from the first redis- 
tribution will not necessarily be permanent. Under the 
influence of production and consumption, they may, and 
under ordinary conditions will, recede somewhat toward 
their original respective positions. 

§ 3. When Bimetallism Succeeds 

So much for the first case, where x is larger than the con- 
tents of the money reservoir below mm. In the second 
case, X is supposed to be smaller than the contents of the 
money reservoir below mm; that is, there is not enough 
silver to push all the gold out of circulation. Under these 
circumstances the opening of the pipe — the opening of the 
mints to silver — will bring the whole system of liquids 
to the common level mm. In other words, the premium 
on gold bullion will disappear (Fig. 12 &), and its purchas- 
ing power and the purchasing power of silver bulhon will 
be a mean between their original purchasing powers, this 
mean being the distance of the mean fine mm below 00. In 
other words, bimetalhsm succeeds in this case. That is, it 
will establish and maintain an equality for a time between 
the gold and silver dollars in the money reservoir. 

The equihbrium we have found is a mere equalization 
of levels produced by a redistribution of the existing stocks 
of gold and silver among the various reservoirs. It will be 
disturbed as soon as these stocks are disturbed. A per- 



OPERATION OF MONETARY SYSTEMS 



215 



manent equilibrium requires that the stocks shall remain 
the same — requires, in other words, an equality between 
production and consumption for each metal. After the 
inrush of silver, from the silver bullion to the money reser- 
voir, it is evident that the production and consumption of 
gold need no longer be equal to each other, nor need the 




Fig. 12. 



production and consumption of silver be equal to each other. 
The same stimulation of silver production and discourage- 
ment of gold production will occur that occurred in the 
first case. The result may be that, after all, silver will, in 
the end, entirely displace gold, or again it may not. If a 
position of the film be found at which the production and 
consumption of gold are equal to each other, and the pro- 



2l6 ELEMENTS OP ECONOMIC SCIENCE 

duction and consumption of silver are likewise equal to 
each other, there will be equilibrium. This equihbrium 
may be upset later and the film driven to the right or the 
left as new gold or silver is discovered and flows into the 
system of reservoirs from one side or the other. But bi- 
metallism will continue to keep gold and silver dollars 
equivalent until the film happens sometime to be driven 
to either extreme position. Such a fate is in the end alto- 
gether probable. Then the two kinds of dollars diverge in 
value and only the cheaper metal remains as money. 

§ 4. The '' Limping " Standard 

Bimetallism is to-day a subject of historical interest only» 
It is no longer practiced. But its former prevalence has 
left behind it in many countries, including France and the 
United States, a monetary system which is sometimes called 
the " limping " standard. Such a system results when, in 
a system of straight bimetallism, before either metal can 
wholly expel the other, the mint is closed to one of them, but 
the coinage that has been accomplished up to date not 
recalled. Suppose silver to be the metal thus excluded, — 
as in France and the United States. Any money already 
coined in that metal and in circulation is kept in circula- 
tion at par with gold. This parity may continue even if 
limited additional amounts of silver be coined from time to 
time. There will then result a difference in value between 
silver bullion and silver coin, the silver coin being over- 
valued. This situation is represented in Figure 13. Here 
the pipe connection between the money reservoir and the 
silver-bullion reservoir has been, as it were, cut off — or, 
let us say, stopped by a valve which refuses passage of silver 
into the money reservoir, but does not prevent passage from 
the money reservoir to the bullion reservoir; for no law 
ever can prevent the melting down of silver coins into bullion. 
Newly mined silver cannot now become money, and thus 



OPERATION OF MONETARY SYSTEMS 



217 



lower the purchasing power of the money. On the other 
hand, new suppHes of gold continue to affect the value of 
the currency, as before, not only of the gold but also of 
the concurrently circulating overvalued silver. If more 
gold should flow into the money reservoir, it would raise the 
currency level. Should this level ever become higher than 
the level of the silver bullion reservoir, silver would flow 
from the money reservoir into the bullion reservoir; for 
the passage in that direction {i.e. melting) is still free. So 
long, however, as the currency level is below the silver level, 




Fig. 13. 



i.e. so long as the coined silver is worth more than the un- 
coined, there will be no flow of silver in either direction. 
The legal prohibition prevents the flow in one direction, and 
the laws of relative levels prevent its flow in the other. 

In the case just discussed, the value of the coined silver 
will be equal to the value of gold at the legal ratio. Pre- 
cisely the same principle applies in the case of any money 
the coined value of which is greater than the value of its 
constituent material. Take the case, for instance, of paper 
money. So long as it has the distinctive characteristic of 
money, — general acceptability at its legal value, — and is 
limited in quantity, its value will ordinarily be equal to 
that of its legal equivalent in gold. If its quantity in- 
creases indefinitely, it will gradually push out all the gold 



2l8 ELEMENTS OF ECONOMIC SCIENCE 

and entirely fill the money reservoir, just as silver would 
do under genuine bimetallism if produced in sufficiently 
large amounts. Credit money and credit in the form of 
bank deposits have this effect. To the extent that they are 
used, they lessen the demand for gold, decrease its value as 
money, and cause more of it to go into the arts or to other 
countries. 

So long as the quantity of silver or other token money, e.g. 
paper money, is too small to displace gold completely, gold 
will continue in circulation. The value of the other money 
in this case cannot fall below that of gold. For if it should, it 
would by Gresham's Law displace gold, which we have sup- 
posed it is not of sufficient quantity to do. The parity 
between silver coin and gold coin, under the '' limping '' 
standard, is therefore not necessarily dependent on any 
redeemability in gold, but may result merely from limita- 
tion in the amount of silver coin. Such hmitation is usu- 
ally sufficient to maintain parity despite irredeemabihty. 
This is not always true, however ; for if the people should 
lose confidence in some form of irredeemable paper or token 
money, even though it were not overissued, it would de- 
preciate and be nearly as cheap as money is in the raw state. 
A man is willing to accept money at its face value so long 
as he has confidence that every one else is ready to do the 
same. But it is possible, for instance, for a mere fear of 
overissue to destroy this confidence. The payee, who 
under ordinary circumstances submits patiently to what- 
ever money is a customary or legal tender, may then take 
a hand and insist on " contracting out " the offending stand- 
ard. That is, he may insist on making contracts in terms 
of the better metal, — gold, for instance, — and thus con- 
tribute to the further downfall in value of the depreciated 
paper. 

Irredeemable paper money, then, like our irredeemable 
silver dollars, may circulate at par with other money if 
limited in quantity and not too unpopular. If it is gradu- 



OPERATION OF MONETARY SYSTEMS 219 

ally increased in amount, such irredeemable money may 
expel all metallic money and be left in undisputed posses- 
sion of the field. 

But though such a result — a condition of irredeemable 
paper money as the sole currency — is possible, it has never 
proved desirable. On the contrary, irredeemability is a 
constant temptation to abuse, and this fact alone causes 
business distrust and discourages long-time contracts and 
enterprises. Irredeemable paper money has almost in- 
variably proved a curse to the country employing it. While, 
therefore, redeemability is not absolutely essential to pro- 
duce parity of value with the primary money, it is prac- 
tically a wise precaution. The lack of redeemability of 
silver dollars in the United States is one of the chief defects 
in our unsatisfactory monetary system and a continuing 
danger. 

§ 5. The " Limping " Standard in the United States 

Among the nations which now have the limping standard 
is the United States. In 1792, Congress adopted complete 
bimetallism. Full legal-tender quality was given to both 
gold and silver coins; both were to be coined freely and 
without limit at the ratio of 15 ounces of silver to i of gold. 
This coinage ratio was soon found to be below the bulHon 
or market ratio ; it overvalued silver, as money, and con- 
sequently gold (which was, as bullion, the dearer or better 
money) tended to leave the country, so that although nomin- 
ally bimetalHc, the country came actually to a silver basis. 

Influenced partly by the desire to bring gold back into 
circulation, and partly also perhaps by the supposed dis- 
coveries of gold in the South, Congress passed acts in 1834 
and 1837 establishing the ratio of " 16 to i," — or, more 
exactly, 16.002 to i in 1834, and 15.998 to i in 1837. Whereas 
silver money had been overvalued by the previous laws, by 
these new laws gold money was overvalued. That is, the 



220 ELEMENTS OF ECONOMIC SCIENCE 

commercial ratio continued to be near 15I to i, while the 
monetary ratio was slightly greater. This remained the 
case up to 1850 ; consequently, in accordance with Gresham's 
Law, gold money, now the cheaper, drove out silver money, 
and the United States became a gold-standard country. 
In 1853, to prevent the exportation of our subsidiary silver 
coins their weight was reduced. 

The United States continued to be a gold-using country 
until the period of the Civil War, during which " green- 
backs,^^ or United States notes, were issued in considerable 
excess. Again Gresham's Law came into operation. Gold 
was in turn driven from the currency, and the United States 
came to a paper standard. For some years after the close 
of the war the country remained on a paper standard, httle 
gold being in circulation, except on the Pacific coast, and 
not much silver anywhere. 

In 1873 Congress passed a law (called by bimetallists 
the " Crime of '73 ") by which the standard silver dollar 
was entirely omitted from the list of authorized coins. Of 
course this could not have had any immediate effect on the 
flow of gold and silver, because the country was at the time 
on a paper basis. But when specie payments (i.e. gold and 
silver payments) were resumed in 1879, this repeal of the 
free coinage of silver brought the country to a gold standard, 
not to a silver one. Had it not been for the law of 1873, the 
United States, when it returned in 1879 to a metallic basis, 
would have been a silver country with a standard consid- 
erably below the gold standard it actually reached. Our 
monetary problems would then have been very different 
from what they actually became. 

The greenbacks, however, were not all canceled. By 
the express provision of a law passed in 1878 nearly 
$347,000,000 of the '' greenbacks " were retained in cir- 
culation, and have been in circulation ever since. They 
have been kept at par with gold because : (i) they are 
limited in amount ; (2) they are redeemable in gold on de- 



OPERATION OF MONETARY SYSTEMS 221 

mand ; (3) they are receivable for taxes and are legal tender. 
But in returning to a gold basis, we reintroduced the silver 
dollar in a minor role. Although the free coinage of silver 
was not resumed, the advocates of silver, through the 
'' Bland-AlHson Act " of 1878 and the '' Sherman Act " of 
1890 which replaced it, succeeded in pledging the govern- 
ment to the purchase of large, but not unlimited, amounts 
of silver and the coinage of a large, but not unlimited, 
number of silver dollars. The Bland- Allison Act required 
the Secretary of the Treasury to purchase every month 
from $2,000,000 to $4,000,000 worth of silver and to coin 
it into standard silver dollars. The Sherman Act required 
the purchase, every month, of 4,500,000 ounces of silver. 

Under these acts 554,000,000 silver dollars were coined, 
although less than 20 per cent of them have ever been put 
in actual circulation. Silver certificates redeemable in silver 
dollars on demand, and, for a time, treasury notes, have 
circulated in the place of this immense mass of silver ; the 
silver dollars (and therefore the silver certificates) maintain 
their value on a parity with gold primarily because they 
are limited in supply. Also in practice, though not by any 
compulsion of law, they are redeemed on demand in any 
form of money desired, including gold. No law directly 
provides for the redemption of silver certificates in gold, 
but it is made the duty of the Secretary of the Treasury to 
take such measures as will maintain their parity with gold. 

In 1893 the Sherman Act was repealed, and in 1900 a law 
was passed specifically declaring that the United States 
shall be on a gold basis. 

§ 6. Our Present Monetary System 

The system of the limping standard, now obtaining in the 
United States, logically forms a connecting Hnk between 
complete bimetaUism and those " composite " systems by 
which 'any number of different kinds of money may be 



222 ELEMENTS OF ECONOMIC SCIENCE 

simultaneously kept in circulation. The manner in which 
most modern civilized states have solved the problem of 
concurrent circulation has been to use gold as a standard, 
and to use silver, nickel, and copper chiefly as subsidiary 
money, limited in quantity, with, in most cases, limited 
amounts of paper money, the latter being usually redeem- 
able. The possible variations of this composite system are 
unlimited. In the United States at present we have a sys- 
tem which is very complicated and objectionable in many 
of its features — especially (as we shall presently see) in 
its lack of elasticity. Gold is the standard and is freely 
coined. A limited number of silver dollars, worth, money- 
wise, more than double their value bullion- wise, are the 
heritage of former bimetallic laws rendered inoperative by 
the paper money of the Civil War and expressly repealed 
in 1873. The [two unfortunate attempts of 1878 and 1890 
to return halfway to bimetallism by the purchase of silver 
— attempts discontinued in 1893 — have greatly swollen 
the volume of coined silver. The attempt to force silver 
dollars into circulation was not acceptable to the business 
world, and Congress therefore issued two forms of paper to 
take their place. The chief form is the " silver certificate." 
For each silver certificate a silver dollar is kept in the 
vaults of the United States government. 

The absurdity of the situation consists in the fiction 
that somehow the silver keeps paper at par with gold. The 
paper would keep its parity with gold just as well if there 
were no silver. A silver dollar as silver is worth less than 
a gold dollar just as truly as a paper dollar, as paper, is 
worth less than a gold dollar. The fact that the silver is 
worth half a dollar, while the paper is worth only a frac- 
tion of a cent, will not avail in the least to make the paper 
worth a whole dollar. A pillar which only reaches half- 
way to the ceiling cannot hold the ceiling up any more than 
a pillar an inch high. 

The paper representatives of silver might always con- 



OPERATION OF MONETARY SYSTEMS 223 

tinue to circulate as well as they do now, even if the '^ sil- 
ver behind them " were non-existent, except that the 
absurdity of the situation would then be so apparent that 
they would probably be retired. Whether the half-billion 
dollars of new currency, which came into circulation with 
the Bland and Sherman Acts, are of silver, overvalued to 
the extent of 50 per cent, or of paper, overvalued to the 
extent of 100 per cent, does not really affect the principle 
of the limping standard which keeps silver dollars at par 
with gold. The idle silver in the treasury vaults repre- 
sents mere waste, a subsidy given by the government to 
encourage silver mining. Its only real effect to-day is to 
mislead the pubHc into the belief that in some way it keeps 
or helps to keep silver certificates at par with gold; whereas, 
it is kept at par simply by its Hmited amount. It cannot 
fall below par without displacing gold, and it cannot displace 
gold because there is not enough of it. 

Another and equally useless anomaly is the existing vol- 
ume of ^' greenbacks." These are United States govern- 
ment notes. Under the law of 1875, the greenbacks were 
by 1879 retired in sufficient numbers to restore parity with 
gold ; but by a counterlaw of 1878, 347,000,000 of them were 
kept in circulation and are in circulation now. As soon as 
redeemed, they must be reissued ; they cannot be retired. 
These are a fixed ingredient in our money poi pourri, neither 
expansive nor shrinkable. It is absurd to redeem but not 
retire — in fact, almost a contradiction in terms. This ab- 
surdity has at times seriously embarrassed the government. 

The next feature of our currency to be considered is the 
bank note. Although the National Banks acts wiped out 
the old, ill-assorted state bank notes by taxing them out of 
existence, and supplied us with a better and uniform sys- 
tem of national bank notes, it tied these notes up with the 
war debt, and they have remained so tied ever since, in 
spite of the fact that the advantages of the connection have 
long been terminated and the disadvantages have grown 



224 ELEMENTS OE ECONOMIC SCIENCE 

acute. National bank notes cannot legally be issued in 
excess of the government debt, however urgent the need 
for them; nor can the government pay its debt without 
thereby compelling national banks to cancel their notes. 
The result is an inelastic currency which, instead of adjust- 
ing itself to the seasonal fluctuations in trade, and thus 
mitigating the ensuing variations in the price level, remains 
a hard and solid mass to which the other elements in the 
equation of exchange must adapt themselves. 

It is clear that the elements of our currency just enu- 
merated (except gold) are inelastic, i.e. practically fixed 
in quantity. The remaining elements, namely, fractional 
and minor coins, are the only ones besides gold which, 
as regards their proportion to other money, are adjustable 
to changing conditions. The government certificates of 
deposit of gold and currency are not adjustable, because 
they are scarcely independent features, being simply con- 
venient receipts for deposits of gold or of greenbacks. 

In the United States, then, we have a currency system 
in which gold, the basis of it all, constitutes directly, or by 
means of gold certificates, about one third of the total mone- 
tary circulation, and in which the remainder consists ahnost 
wholly of elements which are inelastic and almost unchange- 
able. Consequently, to meet any modification in other 
factors of the equation of exchange, — such, for instance, 
as trade, — the gold in circulation must bear the burden. 
But any modification of the gold in circulation can cause 
only one third as great a proportionate change in the total 
money in circulation, and almost all the burden of adjust- 
ing the quantity of money to the other changes in the equa- 
tion of exchange is thrown on gold. As gold requires time 
for minting or transportation, the adjustment is slow and 
clumsy as compared with the prompt issue or retirement 
of bank notes practiced in other countries. The seasonal 
changes in the purchasing power of money, as well as the 
changes connected with crises and credit cycles, are there- 
fore greatly and unnecessarily aggravated. 



CHAPTER XIV 

CONCLUSIONS ON MONEY 

§ I. Can " other Things remain Equal?" 

The chief purpose of the last six chapters is to set forth 
the causes determining the purchasing power of money. 
This purchasing power has been studied as the effect of 
three, and only three, groups of causes. The three groups 
center on currency, on its velocity, and on the volume of 
trade. These and their effects, prices, we saw to be con- 
nected by an equation called the equation of exchange, 
MV -}- M'V' = '^pQ. The three causes, in turn, we found 
to be themselves effects of antecedent causes lying entirely 
outside of the equation of exchange, as follows : the volume 
of trade will be increased, and therefore the price level 
correspondingly decreased by the differentiation of human 
wants ; by diversification of industry ; and by facihtation 
of transportation. The velocities of circulation will be in- 
creased, and therefore the price level increased correspond- 
ingly by improvident habits; by the use of book credit; 
and by rapid transportation. The quantity of money will 
be increased, and therefore the price level increased cor- 
respondingly by the import and minting of money, and, 
antecedently, by the mining of the money metal; by the 
introduction of another and initially cheaper money metal 
through bimetalhsm ; and by the issue of bank notes and 
other paper money. The quantity of deposits will be in- 
creased, and therefore the price level increased correspond- 
ingly by extension of the banking system and by the use 
of book credit. The reverse causes produce, of course, 
reverse effects. 

Q 225 



226 ELEMENTS OF ECONOMIC SCIENCE 

Thus, behind the three sets of causes which alone affect 
the purchasing power of money, we find over a dozen ante- 
cedent causes. If we chose to pursue the inquiry to still 
remoter stages, the number of causes would be found to 
increase at each stage in much the same way as the number 
of one's ancestors increases with each generation into the 
past. In the last analysis myriads of factors play upon the 
purchasing power of money. But it would be neither feas- 
ible nor profitable to catalogue them. The value of our 
analysis consists rather in simplifying the problem by set- 
ting forth clearly the three proximate causes through which 
all others whatsoever must operate. At the close of our 
study, as at the beginning, stands forth the equation of 
exchange as the great determinant of the purchasing power 
of money. With its aid we see that normally the quantity 
of deposit currency varies directly with the quantity of 
money, and that therefore the introduction of deposits does 
not disturb the relations we found to hold true before. 
That is, it is still true that (i) prices vary directly as the 
quantity of money, provided the volume of trade and the 
velocities of circulation remain unchanged ; (2) that prices 
vary directly as the velocities of circulation (if these veloci- 
ties vary together), provided the quantity of money and the 
volume of trade remain unchanged; and (3) that prices 
vary inversely as the volume of trade, provided the quan- 
tity of money — and therefore deposits — and their veloci- 
ties remain unchanged. 

But the question now arises, can the factors here sup- 
posed to ''remain unchanged" actually do so? To this 
we answer, " Yes, with one exception." A change in the 
volume of trade (in a certain case now to be explained) may 
affect, besides prices, the velocities of circulation so that 
the supposition that these velocities '' remain unchanged " 
becomes untrue. The case in which a change in trade effects 
changes in velocities of circulation is this : when the change 
in trade more than keeps pace with the changes in popu- 



CONCLUSIONS ON MONEY 227 

lation so that it involves a change in per capita trade. At 
a given price level, the greater the per capita expenditure, 
the more rapid the individual turnover. The rich have a 
higher rate of turnover than the poor. They spend money- 
faster, not only absolutely, but relatively, to the money they 
keep on hand. Statistics collected at Yale University of 
several hundred cases of individual turnover show that. 
The man who spends much, though he needs to carry more 
money than the man who spends httle, does not need to 
carry as much in proportion to his expenditure. This is 
what we should expect; since, in general, the larger any 
operation, the more economically it can be managed. 

We may therefore infer that, if a nation grows richer per 
capita, the velocity of circulation of money will increase. 
This proposition, of course, has no reference to nominal 
increase of expenditure. As we have seen, a doubling of all 
prices, wages, and salaries would not affect anybody's rate 
of turnover of money, except nominally. Each payer would 
need to make exactly twice the expenditure for the same 
actual result and to keep on hand exactly twice the money 
in order to meet the same contingencies in the same way. 
The real expenditure of a person, on the other hand, is 
measured by the comparative quantity of things bought, not 
by their value in money. We conclude, therefore, that a 
change in the volume of trade, when it affects the per capita 
trade, affects velocity of circulation as well, i.e. real 
velocity. It is, in fact, another name for the volume of 
trade of that person. 

We find, then, that an increase in trade, unlike an in- 
crease in currency or in velocities, has other effects than 
simply on prices ; for, in fact, it increases the magnitudes 
on the opposite side of the equation. But with the excep- 
tion above named, and apart from transition periods, the 
proportions already stated still hold true. In particular, 
a change in the quantity of money causes an exactly pro- 
portional change in prices. 



2 28 ELEMENTS OF ECONOMIC SCIENCE 

The " quantity theory " does not claim that while the 
quantity of money in circulation (M) is increased, other 
causes may not at the same time affect M\ V, V\ and the 
Q's, and thus aggravate or neutralize the effect of M on the 
^'s. But these are not the effects of M. So far as M by 
itself is concerned, its effect is only on the p's and is strictly 
proportional to its quantity. 

The importance and reality of this proposition is not 
diminished in the least by the fact that these other causes 
do not, as a matter of fact, remain quiescent and allow the 
effect on the ^'s of an increase in M to be seen separately 
from all other effects. The effects of changes in M are 
blended with the effects of changes in the other factors in 
the equation of exchange just as the effects of gravity upon 
a falling body are blended with the effects of the resistance 
of the atmosphere. 

Our main conclusion, then, is that we find nothing to inter- 
fere with the truth of the quantity theory ; that variations 
in money (M) produce, normally, proportional changes in 
prices. 

We have now finished with the principles determining 
the purchasing power of money. By the aid of these 
principles the studerit should be able to avoid hereafter 
most of the fallacies and pitfalls which beset the subject. 
He will find it a useful exercise to turn back to Chapter I 
and test himself by analyzing as many as he can of the 
money fallacies there stated. The others we hope to clear 
up in later chapters. 

§ 2. An Index Number of Prices 

We have been studying the causes determining the pur- 
chasing power of money or, its reciprocal, the level of prices. 
Hitherto we have not defined exactly what a " general level '* 
of prices may mean. There was no need of such a defini- 
tion so long as we assumed, as we have usually done hitherto^ 



CONCLUSIONS ON MONEY 229 

that all prices move in perfect unison. But practically, 
prices never do move in perfect unison. If some ^'s do not 
rise enough to preserve our equation, others must rise more. 
If some rise too much, others must rise less. The case is 
further complicated by the fact that some prices cannot 
adjust themselves at all and some can adjust themselves 
but tardily. A price fixed by contract cannot be affected 
by any change coming into operation between the date 
of the contract and that of its fulfillment. The existence of 
such contracts constitutes one of the chief arguments for a 
system of currency such that the uncertainties of its pur- 
chasing power are the least possible. Contracts are a 
useful device; and an uncertain monetary standard dis- 
arranges them and discourages their formation. Even in 
the absence of explicit contracts, prices may be kept from 
adjustment by imphed understandings and by the mere 
inertia of custom. And besides these restrictions on free 
movement of prices there are often legal restrictions ; as, 
for example, when railroads are prohibited from charging 
over two cents per passenger per mile, or when street rail- 
ways are Hmited to five-cent or three-cent fares. What- 
ever the causes of non-adjustment, the result is that the 
prices which do change will have to change in a greater ratio 
than they would were there no prices which do not change. 
Just as an obstruction put across one half of a stream 
causes an increase of current in the other half, so any de- 
ficiency in the movement of some prices must cause an 
excess in the movement of others. 

Another class of goods, the price of which cannot fluctu- 
ate greatly with other prices, are those special commodi- 
ties which consist largely of the money metal. Thus, in a 
country employing a gold standard, the prices of gold for 
dentistry, of gold rings and ornaments, gold watches, gold- 
rimmed spectacles, gilded picture frames, etc., instead of 
varying in proportion to other prices, always vary in a 
smaller proportion. The more predominantly the price of 



230 ELEMENTS OF ECONOMIC SCIENCE 

the article depends upon the gold as one of its raw materi- 
als, the narrower is the range of variation. 

From the fact that gold-made articles are thus more or 
less securely tied in value to the gold standard, it follows 
also that the prices of substitutes for such articles will 
tend to vary less than prices in general. These substitute 
articles will include silver watches, ornaments of silver, 
and various other forms of jewelry, whether containing 
gold or not. 

A further dispersion of prices is produced by the fact 
that the special forces of supply and demand are playing 
on each individual price, and causing relative variations 
among them, and although (as we have before emphasized) 
these prices cannot affect the general price level, they can 
affect the number and extent of individual divergencies 
above and below that general level. 

It is evident, therefore, that prices must constantly change 
relatively to each other, whatever happens to their general 
level. It would be as idle to expect a uniform movement 
in prices as a uniform movement for all bees in a swarm. 
On the other hand, it would be as idle to deny the existence 
of a general movement of prices because they do not all 
move alike as to deny a general movement of a swarm of 
bees because the individual bees have different movements. 

Besides these changes in individual prices, there will be 
corresponding changes in the quantities of the commodities 
which are exchanged at these prices respectively. In other 
words, as each p changes, the Q connected with it will 
change also ; because usually any influence affecting the 
price of a commodity will also affect the consumption 
of it. 

We see, therefore, that it is well-nigh useless to speak of 
uniform changes in prices (^'s) or of uniform changes in 
quantities exchanged (Q's). Therefore, instead of suppos- 
ing such uniform changes, we must now proceed to the 
problem of developing some convenient method of averag- 



CONCLUSIONS ON MONEY 23 1 

ing these two groups of un-uniform changes. We must 
formulate two composite or average magnitudes : the price 
level and the volume of trade. 

It is desired, then, in the equation of exchange, to convert 
the right side, S/^Q, into the form PT, T, measuring the vol- 
ume of trade, and P expressing the price level at which this 
trade is carried on. This P is what we shall call an " index 
number," or average. These magnitudes, price level (P) 
(the index number of prices in general) and volume of trade 
(r) need now to be more precisely formulated. 

T is conceived as the sum of all the Q's, and P as the 
average of all the ^'s. 

To carry out these definitions in practice, suitable units 
of measure for the various articles must be selected. The 
ordinary units in which the various Q's are measured will not 
be the most suitable. Coal is sold by the ton, sugar by the 
pound, wheat by the bushel, etc. If we should merely add 
together these tons, pounds, bushels, etc., and call their 
grand total so many " units " of commodity, we should 
have a very arbitrary summation. The system becomes 
less arbitrary and more useful for the purpose of comparing 
price levels in different years if we use, as the unit for 
measuring any goods, not the unit in which it is commonly 
sold, but the amount which constitutes a " dollar's worth " 
at some particular year called the base year. Then every 
price in the base year becomes exactly one dollar, and the 
average of all prices in that year also becomes exactly one 
dollar. Any other year, the average price {i.e. the average 
of the prices of the newly chosen units which in the base 
year were worth a dollar) will be the index number repre- 
senting the price level, while the number of such units will 
be the volume of trade. 

Introducing, then, our newly found magnitudes P and T 
into the equation of exchange, it assumes the form 

MV-\-M'V' = PT, 



232 ELEMENTS OF ECONOMIC SCIENCE 

and its right member is the product of the index number P 
(or average of prices) multipHed by (the volume of trade) 
T (or sum total of units sold). 

This completes all we need say of the theory of index 
numbers, or average prices. In actually averaging the price, 
say in 1910, of various articles (the prices of those amounts 
which were a dollar's worth in, say, 1900) we must, of course, 
take due account of the relative importance of these various 
articles. The prices of wheat or iron are to be given luore 
weight in constructing our average than those of tooth- 
picks or eyeglasses, for the trade in wheat or iron is far 
more important than the trade in toothpicks or eyeglasses. 
There are various ways of giving the proper " weight " to 
different articles, but the results differ so Httle from each 
other that it is not worth our while to consider them. 

§ 3. The History of Price Levels 

It is impossible to have absolutely accurate index num- 
bers, but those constructed for recent years by the United 
States Bureau of Labor are accurate enough for all prac- 
tical purposes. For the remote past we have only very 
rough index numbers, because the records of prices in past 
times are so defective. These rough index numbers are suf- 
ficient, however, to show that the general trend of prices 
during the last ten centuries has usually been upward. We 
may say that prices are now about ten times as high as a 
thousand years ago, and that they are from four to six 
times as high as in the period between a.d. 1200 and a.d. 
1500. And since the last-named date also, or since shortly 
after the discovery of America, prices have almost steadily 
risen. The successive opening of mines has been largely 
responsible for this rise. 

From this telescopic view of the past we turn to what 
may be called by contrast a microscopic view of the present. 
We shall confine ourselves to the events of the last decade 
and a half in the United States. 



El i '^ ^ 



tr^TI f^ "898 



ral © " 




CONCLUSIONS ON MONEY 233 

For the years 1 896-1 909 we are able to construct fairly 
accurate estimates of all the factors in the equation of 
exchange, M, M\ V, V\ P, T. The statistics of these mag- 
nitudes for the fourteen years mentioned are all presented 
in Figure 14. In this diagram the equation of exchange 
for each year is represented by the mechanical balance 
described in a previous chapter. 

We note that every factor has greatly increased in the 
fourteen years considered. The quantity of money in 
circulation {M, represented by the purse) has nearly 
doubled; bank deposits subject to check (M\ represented 
by the bank book) have more than doubled; the volume 
of trade {T, represented by the weight at the right) has 
doubled ; the velocity of circulation of money ( V, repre- 
sented by the " arm " of the purse, or its distance from the 
fulcrum) has increased slightly, and the velocity of circu- 
lation of bank deposits {V\ represented by the *' arm " 
of the bank book) has increased considerably. As the 
net result of these changes, the index number of prices (P, 
or the " arm " of the weight at the right) has increased 
about two thirds. The price level of 1909 is taken as 100 
per cent. On this scale the price level of 1896 is 60 per 
cent, and that of the other years, as indicated. The volume 
of trade is represented as the number of " dollars' worth 
in 1909." Thus the actual value of trade in 1909 was 
$387,000,000,000 worth, or over a biUion a day. The trade 
in 1896 was $191,000,000,000 worth, reckoned, of course, 
at the prices of 1909, not at the prices of 1896. At the 
prices of 1896 the value of the trade in 1896 was only 
$115,000,000,000. This is PT, i.e. $191,000,000,000 X 60 
per cent. 

It is interesting to observe the changes in all the factors 
before and after the crisis of 1907. These changes, it will 
be noted, fulfill the principles explained in the chapter 
on crises. 

From 1896 to the present time, prices have been rising 



234 ELEMENTS OF ECONOMIC SCIENCE 

because of the extraordinary rise in gold production and 
consequent increase in money media of all kinds. 

The gold of South Africa, combined with the gold from 
the rich mines of Cripple Creek and other parts of the 
Rocky Mountain Plateau, and reenforced by gold from the 
Klondike, has caused, and is still causing, a rapid rise of 
prices. 

The history of prices has in substance been a race between 
the increase in media of exchange {M and M') and the in- 
crease in trade (T), while we assume that the velocities of 
circulation have changed in a much less degree. Some- 
times the circulating media shoot ahead of trade, and then 
prices rise. Sometimes, on the other hand, circulating media 
lag behind trade, and then prices fall. 

The outlook for the future apparently promises a con- 
tinued rise of prices due to a continued increase in the gold 
supply. 

The most careful review of present gold-mining condi- 
tions suggests the probabihty of a continuance of gold 
inflation for a generation or more. De Launay, an excel- 
lent authority, says, " For at least thirty years we may 
count on an output of gold higher than, or at least compar- 
able to, that of the last few years." This gold will come 
from the United States, Alaska, Mexico, the Transvaal, 
and other parts of Africa and AustraHa, and later from 
Columbia, BoHvia, Chih, the Ural Province, Siberia, and 
Korea. 

It is difficult to predict the future growth of trade, and 
therefore impossible to say for how long gold expansion 
will keep ahead of trade expansion. That for many years, 
however, gold will outrun trade seems probable, for the 
reason that there is no immediate prospect of a reduction 
in the percentage growth of the gold stock nor an increase 
in the percentage growth of trade. Not only do mining 
engineers report untold workable deposits in outlying 
regions (for instance, a full bilUon of dollars in one region 



CONCLUSIONS ON MONEY 235 

of Columbia alone), but any long look ahead must reckon 
with possible and probable cheapening of the processes of 
gold extraction. The cyanide process, for instance, has 
made low-grade ores pay which did not pay before. If we 
let imagination run a little ahead of our times, we may 
expect similar improvements in the future whereby still 
lower grades may be worked, or possibly the sea compelled 
to give up its gold. Like the surface of the continents, the 
waters of the sea contain many thousand times as much 
gold as all the gold thus far extracted in the whole history 
of the world. We have seen that inflation is, in general, an 
evil, Hkely to culminate in a crisis. It is therefore to be 
hoped that the knowledge of how to get this hidden treasure 
may not be secured, or at least, may be secured but gradu- 
ally. 

It is unfortunate that the purchasing power of money 
should be always at the mercy of every chance in gold 
mining. There are few businesses more subject to chance 
than gold mining. There are always chances of finding 
new gold deposits, chances of their '' panning out " well 
or ill, and chances of new methods of metallurgy. On 
these fitful conditions the purchasing power of money 
is dependent. Consequently every one interested in long- 
time contracts, whether debtor or creditor, stockholder or 
bondholder, wage earner or savings bank depositor, is made 
to some extent a partaker in these chances. In a sense 
every one of us who uses gold as a standard for deferred 
payments becomes a gold speculator. We all take our 
chances as to what the future dollar shall be. The prob- 
lem of making the purchasing power of money stable so 
that a dollar may he a dollar — the same in value at one 
time as another — is one of the most serious problems in 
apphed economics. As yet it has received very little at- 
tention. The advocates of bimetallism have claimed that 
*' the bimetalKc standard '^ possesses greater stabiHty than 
either the gold or silver standard. Many other and very 



236 ELEMENTS OF ECONOMIC SCIENCE 

ingenious schemes for a more stable currency have been 
proposed but have received very Httle attention. One 
scheme has been suggested which, although it allows the 
present fluctuations to continue, aims to avoid the evils 
which these fluctuations cause. This is to permit long-time 
contracts to be corrected from time to time, according to 
changes in the purchasing power of money as shown by an 
official index number of prices. Under this plan if a man 
borrowed $1000 in 1910, and prices rose 10% in a year, he 
would have to repay as his principal in 191 1 not simply 
$1000 but 10% more than $1000. His interest payments 
would be corrected in the same way. 

As the consideration of these schemes belongs to applied 
economics, we shall not discuss them here. 



CHAPTER XV 

SUPPLY AND DEMAND 

§ I. Individual Prices presuppose a Price Level 

We have completed our study of the purchasing power of 
money, which, as we have seen, is really a study of price 
levels. Our next topic will be individual prices. It has 
already been shown that individual prices, such, for instance, 
as the price of sugar, presuppose a price level. This fact is 
one reason why we have considered price levels before con- 
sidering individual prices. 

Before proceeding to the causes determining individual 
prices, it will be advisable to explain more fully the propo- 
sition that an individual price presupposes a price level. 

The price of sugar is a ratio between sugar and money. 
Any one who buys sugar balances in his mind the impor- 
tance of the sugar to him against the importance of the 
money which he has to pay for it. In making this com- 
parison, the money stands in his mind for the other things 
which it might buy if not spent for sugar. If the purchas- 
ing power of money is great, it will seem precious in his mind, 
and he will be .nore loath to part with a given amount of it 
than if its purchasing power is small ; that is, the greater the 
power of money to purchase things in general, the less of it 
will be offered for sugar in particular, and the lower the price 
of sugar will therefore become. In other words, the lower 
the general price level, the lower will be the price of sugar. 
In still other words, the price of sugar must sympathize with 
prices in general. If they are high, it will tend to be high, 
and if they are low, it will tend to be low. Before the pur- 
chaser of sugar can decide how much money he is wilHng to 

237 



238 ELEMENTS OF ECONOMIC SCIENCE 

exchange for it, he must have some idea of what else he 
could buy for his money. This explains why a traveler 
feels at first so helpless in a foreign country when he is told 
the price of sugar or of any other article in terms of un- 
familiar units. If the traveler has never heard before of 
kroner, gulden, rubles, or milreis, any prices expressed in 
these units will mean nothing to him. He cannot say how 
many of any one of these units he is wilHng to pay for a 
pound of sugar until he knows how the purchasing power of 
that unit compares, for instance, with that of a cent or with 
that of a dollar. There must thus always be in the minds of 
those who use money some idea of its purchasing power. 
The sellers and buyers of sugar express the amounts they 
are willing to supply or to demand in terms of money, and 
money means to them merely purchasing power over other 
things. It is often said that supply and demand of sugar 
or of any other commodity determine its price, and this is 
true, provided a price level is first assumed. This proviso 
needs emphasis because it is so often overlooked. Although 
the purchasing power of money is assumed, we are usually as 
unconscious of it as we are of the background of a picture 
against which we see and measure the figures in the fore- 
ground. 

§ 2. A Market and Competition 

The terms " supply" and '' demand," say, of sugar, thus 
imply a concealed reference to the purchasing power of money, 
i.e. to prices in general as well as to the price of sugar in par- 
ticular. As we have, through several previous chapters, 
already studied the subject of prices in general, we shall 
hereafter assume that the general level of prices has been 
determined in accordance with the principles set forth in 
those chapters. We are ready to leave these general rela- 
tions and to study the determination of a particular price 
(such as that of sugar) so far as this depends upon its own 
particular supply and demand in its own particular market. 



SUPPLY AND DEMAND 239 

A market for any commodity or good is any assemblage 
of buyers and sellers of that commodity or good. The 
buyers and sellers may be, and usually are, physically near 
each other, as on the New York Stock Exchange, or they 
may be merely connected by telegraph, telephone, or other 
communication, as in the stock market as a whole; for 
the stock market as a whole includes not only the members 
of the stock exchange present or on the floor of the ex- 
change, but the members outside and their numerous cus- 
tomers in and out of the city. It is in the market that 
questions of supply and demand which we are about to dis- 
cuss work themselves out. 

Our study of price determination will fall under two 
heads, according as there is competition or monopoly. For 
the present, we shall assume a condition of perfect compe- 
tition, that is, we shall assume that each man who offers 
to buy or sell does so independently of every one else. Thus, 
if self-interest leads him to do so, a buyer will bid a higher 
price than others, irrespective of their wishes in the matter, 
and likewise a seller will ask a lower price if his independent 
self-interest so leads him. 

But until these independent bids meet, there will be no 
sales. 

When there is a perfect competition, there is only one price 
for all buyers and all sellers. This is evident ; for if there 
were more than one, no buyers would buy at the higher 
prices which had first been asked (and so these must there- 
fore fall), and no seller would sell at the lower prices which 
had been bidden (and so these must therefore rise). The 
watchfulness of one competitor toward the other ehminates 
differences in price ; even if not all buyers and sellers were 
careful to note slight differences in price, the more watchful 
would bring about the same result by becoming " specula- 
tors." They would buy at the lowest prices and sell at 
the highest. Their buying would raise the lowest prices 
and their selling would lower the highest. 



240 



ELEMENTS OF ECONOMIC SCIENCE 



In these ways differences in prices are reduced or entirely- 
eliminated. It is true that in practice there remain slight 
differences in price, even in the same or closely associated 
markets. This fact simply means that competition is often 
imperfect. In our discussion we shall not take account of 
those cases, but consider only the simple case where com- 
petition is perfect. 

§ 3. Demand and Supply Schedules 

The terms " supply " and " demand " have a definite and 
technical meaning in economics, and the reader should note 
the following definitions carefully. 

In any market there is a different demand for sugar at 
different prices. We may define the demand at a given price 
as the amount of sugar which people are wilHng to buy at 
that price. In the same way the supply at a given price is 
the amount which people are wilhng to sell at that price. If 
the price of sugar is 8 cents a pound, the demand for sugar 
in a given community at a given time may be, let us say, 
900 pounds a week. If the price falls to 7 cents, the demand 
would increase, say, to 940 pounds. If the price falls to 6 
cents, the demand would rise, say, to 1000 pounds, and so on. 
The supply of sugar, we shall suppose, changes in the opposite 
way. At 8 cents it may be iioo pounds. At 7 cents, 1050, 
at 6 cents, 1000, etc. The following table shows these 
figures and others, and constitutes what are called ''sched- 
ules" of demand and supply in relation to various prices. 



Price 


Schedules of 
Demand 


Supply 


.08 


900 




IIOO 


.07 


940 




1050 


.06 


1000 




1000 


•05 


IIOO 




900 


.04 


1250 




750 



SUPPLY AND DEMAND 24I 

The schedule of demand is the second column considered 
relatively to the first. It shows the largest quantity which 
will be taken at each given price, or what amounts to the 
same thing, the smallest price at which a given quantity will 
be taken. When the relationship between the two columns 
is expressed in the last of these two ways, it is more con- 
venient to place the second column first, and the first, second ; 
but their order is immaterial. It is their relation to each 
other which constitutes the demand schedule. 

In the same way the relation between the first and third 
columns constitutes the supply schedule. This tells us the 
largest quantities which will be supplied at stated prices, 
or what amounts to the same thing, the lowest prices at 
which stated quantities will be supplied. 

Running the eye down the table, we see that, although the 
supply at first exceeds the demand, as the price falls, de- 
mand increases, and the supply decreases until, when the 
price reaches 6 cents, the supply and demand are equal. 
For prices lower than 6 cents we find the reverse condi- 
tion, demand exceeding supply. 

If the foregoing figures represent the demand and supply 
schedules showing the amounts that buyers are wilHng to 
pay and sellers to give at different prices, it is clear that 
there is only one price that will make supply and demand 
equal. That price is 6 cents, and that is the price that 
supply and demand will finally fix. The price cannot really 
be above 6 cents, for then supply would exceed demand, and 
the price would immediately fall. Nor can it be below, for 
then demand would exceed supply, and the price would rise. 
For instance, if the price were 8 cents, the supply (iioo) 
would exceed the demand (900) by 200 pounds. Those 
wishing to sell this extra amount would then be unable 
to do so except by offering at a lower price, and their 
competition would drive the price down. On the other 
hand, if the price were 4 cents, the demand (1250) would 
exceed the supply (750) by 500 pounds, and those demand- 



242 ELEMENTS OF ECONOMIC SCIENCE 

ing this extra amount would be unable to get it except by 
bidding a higher price, and their competition would then 
drive the price up. 

Since, then, the price cannot really be either above or 
below 6 cents, it must be finally fixed at 6 cents. A price 
which thus makes supply and demand equal is said to 
*' clear the market,'^ and is called the market price. The 
amounts suppUed and demanded at the market price are 
called the amount marketed, i.e. the amount actually bought 
by buyers and sold by sellers. 

§ 4. Demand and Supply Curves 

The relations -discussed can be seen more clearly by 
means of a diagram. In Figure 15 is represented the de- 
mand for sugar at different 
prices. 

As in previous diagrams, 

,0 the two axes OX and OY are 

i • ^ drawn simply for reference, 
j like the equator and the 
al Greenwich meridian in a map. 
J The intersection O of the two 
; axes is called the '' origin." 
• \t Y The diagram is a " map " of 



demand on which the " lati- 
^^' ^^' tude," or the distance above 

the line OX, represents any price ; and the " longitude," the 
distance to the right of the line O Y, represents the amount 
demanded at that price. Let us, for instance, represent an 
assumed price, say 8 cents, by measuring off the " latitude " 
O Y from the origin O. The demand at this price of 8 cents, 
which we have seen to be 900 pounds, is represented by the 
''longitude" yD. We have thus located a point D, the 
" latitude " of which represents a particular price (8 cents), 
and the " longitude " of which represents the demand at 



SUPPLY YND DEMAND 243 

that price (900 pounds) . It will be seen that the " latitude " 
is simply the elevation above the base axis OX, whether we 
measure this " latitude " by the Hne Oy or by Dx. Likewise 
the ^' longitude " is simply the distance of D to the right of 
the axis O Y, whether this distance be measured by yD or by 
Ox. Having found one point, the " longitude " and '' lati- 
tude " of which represent price and the demand at that 
price, we may find in like manner other points, the " lati- 
tudes " and '' longitudes " of which will represent other par- 
ticular prices and the corresponding demands. Several 
such points are indicated on the diagram. It will be seen 
that the lower in the diagram the points, the farther they 
will be to the right. This represents the fact that the lower 
the price, the greater the demand. We may suppose the 
spaces between those various points to be filled by other 
points, all together forming what is called the demand curve. 

A demand curve, then, is a curve such that the '' latitude " 
and '' longitude " of each of its points represent respectively 
a particular price and the particular demand corresponding 
to that price. Thus a demand curve is a graphic picture 
of a demand schedule. 

In precisely the same way 
we may treat supply. In 
Figure 16 let us represent any 
particular price, say 8 cents, 
by the '' latitude " Oy and 
the supply corresponding to 
this price (iioo pounds) by 
the '' longitude " yS. Thus 
we locate a point S such that 
its " latitude " {Oy or xS) Fig. 16. 

represents a particular price, and the '' longitude " {yS or 
Ox) represents the supply at that particular price. In hke 
manner we may locate other points, the " latitudes " of which 
represent other prices and the '' longitudes " of which 
represent the amounts which would be supphed at these 



244 ELEMENTS OF ECONOMIC SCIENCE 

respective prices. These points are so arranged that the 
higher their '^ latitude," the greater their " longitude." 
This represents our assumption that the higher the price, 
the greater the supply. The curve which these points 
form is called a supply curve and is a graphic picture of a 
supply schedule. 

In Figure 17 are drawn both the supply and demand 
curves, the demand curve being DD\ and the supply curve, 

SS\ We have seen that 
- . the demand curve shows 

Id" /s" many different demands at 

.-V— y many different prices, but 

\(p that there is only one price 

y^ X. at which supply and de- 

__^- gij^^^ rnand are equal. We can 

see this clearly in Figiire 

17, for there is only one 

X point (P) in which the two 
Fig. 17. curves intersect. The 

" latitude " of the intersection (P) of the curves DD^ and 
SS^ represents the market price. The " longitude " of P 
represents the amount marketed, which is at once the sup- 
ply at that price and the demand at that price. The point 
P may be called the market point. 

The market price OP^ clears the market, and no other 
price will. If, for instance, we take a higher price, such as 
0P'\ the supply will be represented by the long Une P^' S'^, 
and the demand by the short Hne P'' D'\ leaving the dis- 
tance between them, or D^' S^' , as the excess of supply over 
demand. The effort of sellers to get rid of this excess will 
drive the price down. Thus the market price cannot exceed 
0P\ In Hke manner, the market price cannot be lower than 
0P\ If, for instance, it were only 0P^^\ the demand would 
be F'' B'", and the supply only P^'^ S"\ leaving an 
excess of demand over supply of D" S'" , which at that 
price the buyers are unable to obtain. They will therefore 



SUPPLY AND DEMAND 245 

bid up the price. We see, then, that the only real price is 
0P\ The point P, at which the two curves intersect, is 
the only real point the latitude of which represents the 
market price and the longitude the actual amounts bid and 
sold. Ail the other points in the two curves are hypotheti- 
cal, representing, not what demand and supply actually are, 
but what they would be at other prices than the real 
market price. 

All demand curves descend to the right, but they descend 
at different rates. Those which descend very rapidly rep- 
resent necessities, for the rapid descent means that it re- 
quires a great fall of price to materially affect demand. 
The demand for necessities such as salt does not change 
greatly, whether the price changes much or httle. 

At the other extreme are luxuries, the demand curves 
of which descend very slowly, thus interpreting the fact 
that a sHght fall in price produces a great expansion in de- 
mand. If the price of champagne, for instance, is sUghtly 
changed, the amount of it consumed will be materially 
affected. 

In the same way supply curves may ascend at different 
rates, those ascending speedily being commodities the sup- 
ply of which cannot expand very much, even with a great 
increase in price. At the opposite extreme are the supply 
curves which ascend very shghtly, being those of commodi- 
ties the supply of which can be greatly increased by even a 
small increase in price. 

Most of the articles produced in extractive industries 
such as agriculture or mining are of the rapidly ascending 
type, while manufactured articles often illustrate the 
shghtly ascending type. It requires a great increase in 
the price of coal to materially affect the output of coal 
mines, but it requires only a sHght rise in price of manu- 
factured products to lead to an enormous increase in the 
output. 



246 



ELEMENTS OF ECONOMIC SCIENCE 




Fig. 18. 



§ 5. Shifting of Demand or Supply 

Having represented supply and demand by curves, we 
are now in a position to understand more clearly what is 
Y| meant by " increase of de- 

mand" or "increase of sup- 
ply." These phrases are 
often used loosely, without 
realization that they are am- 
biguous. Increase of de- 
mand, for instance, may 
mean one of two things. It 

may mean a shifting of the 

X market point from one posi- 
tion A to another position^, 
farther to the right, on the same demand curve (Fig. 18), 
or again it may mean a shifting of the entire demand curve 
from the position A to the position B, farther to the 
right, (Fig. 19). ^ 

Both of these meanings are admissible, but they are en- 
tirely distinct. In the same way, "increase of supply '^ 
may mean one of two things, 
either a shifting of the mar- 
ket point A to another posi- 
tion B, farther to the right, 
on the same supply curve, as 
in Figure 20, or a shifting of 
the entire supply curve from 
the position A to the position 
B farther to the right, as in 
Figure 2 1 . We see, therefore, 
that an '^ increase of supply 
or demand" may mean either 
a change of the point on the same curve or a change of 
the curve itself. To distinguish their two meanings we 
shall call the first an increase in the point sense and the 



Y 


A 

V 


B 

\ 

\ 

\ 







X 



Fig. 19. 



SUPPLY AND DEMAND 



247 




second an increase in the curve sense. We shall find that 

the curve sense is the more important and fundamental. 
It will be seen that an increase of demand in the point 

sense is nothing else than 

an increase of supply in the ^ 

curve sense ; for we have 

already made it clear that 

there is only one point 

which is the intersection 

of the two curves, and that 

this point cannot be shifted 

to the right from ^ to 5 on 

the demand curve unless 

the supply curve has shifted 

so as to change the inter- Fig. 20. 

section. Such a shifting is seen in Figure 22. Here the 

demand has increased in the point sense, having changed 

from ^ to 5 on the same demand curve, but it has done 

so only because the supply has increased in the curve sense, 

having shifted from the position of the unbroken supply 

curve to the position of the dotted curve. 

Again, to say that supply 
has increased in the point 
sense is the same thing as 
to say that the demand has 
increased in the curve sense. 
This is shown in Figure 23, 
where the point A on the 
supply curve has shifted to 
B on the same curve, be- 
cause the demand curve had 
shifted from the unbroken 
to the dotted position. 



Y 


/ / 




/ / 
















/ / 




/ / 












A-^^-"'"" 





X 



Fig. 21. 



We should, therefore, be careful to know when we speak 
of a change in demand or supply whether we mean that the 
change is in the point sense or in the curve sense. It seems 



248 



ELEMENTS OF ECONOMIC SCIENCE 




X 



Fig. 22. 



odd at first to think that the increase of demand in one 
sense is really an increase of supply in another sense, and 

vice versa. Because of this 
ambiguity, when one person 
speaks of an increase of sup- 
ply, it means the same thing 
as when another speaks of 
an increase of demand. 

To illustrate the two 
meanings, let us suppose 
that the demand curve con- 
sidered is the demand curve 
for automobiles, and that, 
given the same prices, people 
would demand automobiles now no more and no less than 
they did a few years ago, but that the condition of the 
supply has changed, so that now more automobiles can be 
suppHed for the same price. That would mean that the 
supply curve had shifted to the right, so that its point of 
intersection with the same demand curve has shifted to the 
right. Therefore two things 
have happened on the de- 
mand side. The price has 
fallen, and as a conse- 
quence of that fall of price 
the number of automobiles 
demanded has increased. 
Demand in the point sense 
has increased. But de- 
mand in the curve sense 
has not changed at all. 
People are just as willing as 
before to take an automobile at $4000, but they are willing 
to take more automobiles at present low prices than they 
were wilHng to take at former high prices. What have 
changed are the conditions of supply. 



Y 


\ \ / 




\ V / 




\. \ / 




\ \ r 








\ ^ X 




X '^ y 








^k X n ^r 




^w ^\7^ 




\v^\.^ 




^^^""^^^^w """-.^ 




..^-^^ ^^ 





X 



Fig. 23. 



SUPPLY AND DEMAND 249 

On the other hand, we might take as our illustration an 
article of luxury. In the last few years there has been a 
great change in the attitude of Americans toward works of 
art. Of these we are much more appreciative than we used 
to be, and are willing to pay more, for instance, for a fine 
painting than previously. Thus, for works of art the de- 
mand curve has shifted ; the demand for works of art has 
increased in the curve sense. Consequently, the supply has 
increased in the point sense ; namely, on account of the 
greater demand the price has risen, and therefore owners and 
makers of works of art have offered more for sale. Increase 
of demand in the curve sense brings about increase of 
supply in the point sense, and vice versa. An increase in 
the supply of automobiles in the curve sense brought about 
an increase in the demand for automobiles in the point sense, 
while an increase in the demand for works of art in the curve 
sense brought about an increase in the supply of works of 
art in the point sense. In either case the ultimate change 
is in a curve. There can evidently be no change of points 
of intersection except by a change in at least one of the two 
curves. Hereafter we shall use the phrases '' increase of 
supply " or '' increase of demand " only in the sense of shift- 
ing to the right the supply or demand curve. 

When we shift demand or supply curves, the effect on the 
intersection, that is, on the market price and the amount 
marketed, will depend greatly on the character of the 
curves, whether, for instance, one or both of them ascends 
rapidly or slowly. It will be instructive for the student 
to draw on paper various pairs of intersecting curves where 
one is nearly horizontal or both are, and where one is nearly 
vertical or both are, and to observe the various effects 
thus obtained : first, by shifting the demand curve a given 
distance to the right or left, and second, by shifting the 
supply curve a given distance to the right or left. In 
actual fact, demand and supply curves are constantly shift- 
ing, with the result that their point of intersection is con- 



250 ELEMENTS OF ECONOMIC SCIENCE 

stantly shifting, sometimes to the right, sometimes to the 
left, sometimes up and sometimes down. Consequently 
the market price and the amount marketed are changing 
from time to time. 

The causes which shift the curves are innumerable. 
Changes in taste or fashion will affect demand curves, while 
changes in methods of production will affect the supply 
curves. 

As to the variable point of intersection, we are more in- 
terested in its latitude than in its longitude, for the latitude 
represents the market price. This market price will evi- 
dently rise with a rise in either curve, and fall with a fall in 
either curve. It will also rise with a shifting of the demand 
curve to the right or with a shifting of the supply curve 
to the left; and will fall with a shifting of the demand 
curve to the left of the supply curve to the right. In fact, 
by a leftward change in the demand curve or a rightward 
change in the supply curve, the price may fall to zero. A 
standard example of such a case is furnished by the air we 
breathe, the supply of which is so much more abundant 
than the demand that it bears no price. The same is often 
true of water and of land of inferior quaHties. There are 
milHons of acres of land which may be had for practically 
nothing (a fact of much importance in a future chapter.) 

One cause of shifting demand and supply curves men- 
tioned in a general way at the beginning of this chapter 
may be especially emphasized. This cause is a change in 
the general purchasing power of money. Let us suppose 
that we change our monetary unit so that what is now 50 
cents should be called a dollar. This would mean that the 
purchasing power of a dollar had been cut intwo, or that 
the level of prices had been doubled. We ought, therefore, 
to find that the demand and supply of sugar will have been 
affected so as to double its price, — the latitude of the point 
of intersection, — and this is, in fact, the case. As soon as 
the half dollar became a dollar, the price in " dollars '^ at 



SUPPLY AND DEMAND 



251 




Fig. 24. 



which any given amount of sugar, such as Ox (in Fig. 24) , is 

demanded, will evidently be doubled, becoming xB, which 

is twice xA. If previously 

people were willing to take 

Ox at one price, they are now 

wilHng to take it at double 

that price, because this double 

price means in purchasing 

power exactly the same thing 

as the original price. And in 

fact all points in the demand 

curve will be shifted to be 

twice as high as before. 
In the same way and for 

the same reasons, those who 

have sugar to sell will require twice as high a price as before 

for a given amount; so that, as indicated in Figure 25, 

each point, such as A, in the supply curve, will be shifted 

to twice as high an elevation above the base, OX. 

When the two curves thus shifted are drawn on the same 

axes (see Fig. 26), it is evident that the new point of inter- 
section, B, will be vertically 
over the old point of inter- 
section, A. 

The price of market sugar 
is therefore doubled, though 
the amount marketed is un- 
changed. Simply the doubl- 
ing of the general price level 
carries with it a doubling in 
the price of sugar. Practi- 
cally, of course, it takes time 
to change a price level, and 
while the supply and demand 

curves for sugar may change for many other reasons than 

the doubling in general price level, so far as this cause, 




Fig. 25. 



252 



ELEMENTS OF ECONOMIC SCIENCE 



taken by itself, affects the price of sugar, it doubles it. 
Our analysis of demand and supply curves then brings us 
back to the point already made, that the price of any one 
good like sugar depends partly on the general level of prices, 
or the purchasing power of money. 

We can now see more clearly than before the shallowness 
of the idea that the supply and demand of each individual 
commodity fixes its price independently of other commodi- 
ties. According to this view, the general price level is re- 
garded as the effect of innumerable individual pairs of supply 

and demand curves, each 
^ pair being supposed to com- 

pletely determine some one 
price. The opposite is the 
truth. The general price 
level is not the result of 
the supply and demand of 
sugar in relation to money, 
but is one of the causes 
aft'ecting the supply and de- 
mand of sugar in relation 
to money, for we have seen 
that, as the price level rises 
or falls, the price of sugar rises, and falls, correspondingly. 
We end this chapter, therefore, with the statement with 
which we began, namely, that it is important to distinguish 
between the influences determining the general price level 
and the influences determining an individual price. The 
price level is determined by a comparatively simple mech- 
anism, that of the equation of exchange. It is the result of 
the quantity of money and deposits, the velocities of their 
circulation and the volume of trade. The general price 
level then helps to fix individual prices, although not inter- 
fering with relative variations among them, just as the gen- 
eral level of the ocean helps fix the level of individual waves 
and troughs without interfering with variations among 




Fig. 26. 



' SUPPLY AND DEMAND 253 

them. The tides determine whether a wave shall be as a 
whole high or low, and so the general level of prices, while it 
does not fully fix the price of sugar, determines whether it 
shall be in general high or low. A rise (or fall) in the general 
price level is one of the many causes raising (or lowering) 
the demand and supply curves of sugar. 



CHAPTER XVI 

THE INFLUENCES BEHIND DEMAND 

§ I. Individual demand Schedules and Curves 

We have seen that the market price of any particular 
good is that price in the demand and supply schedules which 
will just clear the market. Both market price and quan- 
tity marketed are determined by the intersection of the sup- 
ply and demand curves. But the supply and demand curves 
are not the ultimate influences determining prices. They 
are only the proximate influences. Beneath and behind 
them he influences more remote and more fundamental. In 
this chapter we shall consider those remoter influences so 
far as they have to do with the demand side of the market. 
Our problem, therefore, is to analyze the demand curve 
into its ultimate elements. In the preceding chapter the 
demand schedule or curve was considered as a cause. In 
this chapter it is considered as an effect of antecedent 
causes. 

In the first place, the demand schedule or curve is for the 
community as a whole ; and this community consists of a 
large number of individuals, each of whom contributes his 
share to the formation of the total demand. In fact, the 
total demand at any price is merely the sum of the in- 
dividual demands at that price. For instance, let the fol- 
lowing table represent the demand schedules for coal of 
Individual No. I and Individual No. II at prices of from 
$12 to $2 per ton : — 

254 



THE INFLUENCES BEHIND DEMAND 



255 



Demand Schedules 



Price 


No. I 

(a) 


No. II 

(&) 


Total 
(a +6) 


$12 


I 





I 


10 


2 





2 


8 


3 





3 


6 


4 


I 


5 


5 


5 


2 


7 


4 


6 


3 


9 


3 


7 


4 


II 


2 


8 


^ 


13 



The last column gives the sum of the demands of these 
two individuals. If we should extend such a table to in- 
clude the demand of all the individuals in the community, 
we would obtain the total demands in the community. The 
total demand schedule is thus found to be merely the sum 
of the individual demand schedules found by adding to- 
gether all the individual amounts demanded at any given 
price. Behind the total demand schedule, therefore, are a 
number of constituent demand schedules. 

The same relation, of course, holds between total and 
individual demand curves. Y 
In Figure 27 let the curve 
d-^d^ represent the demand 
curve for Individual No. I, 
and d^d^ the demand curve 
for Individual No. II. 

At a given price, Oy, the 
demands of these two indi- 
viduals are respectively yd^ 
and yd2- The sum of these 
two demands is represented 
yD. Thus we add the longi- Fig. 27. 




256 



ELEMENTS OF ECONOMIC SCIENCE 



tudes of the two individual demand curves together to get 
the longitude of the combined curve DD\ If, instead of 
two individual demand curves, we should have all the 
demand curves for all the individuals in the market, and 
should add together, as already indicated, the longitudes 
corresponding to given latitudes, that is, the demands cor- 
responding to given prices, we should thereby obtain the 
total demand curve as employed in the previous chapter. 

To see more clearly the relations which the price bears 
to the individual, and to the total, curves of demand, we have 

drawn in Figure 28 an indi- 
vidual demand curve dd\ 
the total demand curve DD^, 
and the total supply curve 
SS\ The intersection of 
the last two determines the 
market price Px (or 0P\ or 
px^), and this price deter- 
mines/or the individual the 
amount P^p (or Ox^) which 
he will take at that price. 
Althousfh, for the market as 

Fig. 28. ° ' 

a whole, supply and demand 
fixes the price Px, for the individual, this price, thus fixed, 
in turn ILxes the amount demanded. 




§ 2. Marginal Desirability 

We have now found that back of the demand curve in 
any market He the individual demand curves of all the 
people who compose that market. The next step is to find 
what causes He back of the individual demand schedule. 
Taking, for instance, the demand curve of Individual No. I, 
we may ask. What are the conditions which determine its 
shape and size? The answer is that it depends upon the 
desires of Individual No. I. It is true that a man may 



THE INFLUENCES BEHIND DEMAND 257 

have a strong desire for something without having any 
demand for it. But this is simply because he desires still 
more the money he would have to spend for it. Every pur- 
chaser of goods balances two desires, the desire for the goods 
and the desire for the money they would cost. On the rela- 
tive strength of these desires depends the price he is willing 
to pay. We have, therefore, to investigate these two de- 
sires, the one for goods, the other for money. We shall 
begin with the desire for the goods. The quahty of an 
article by virtue of which it is desired may be called its 
desirability. The term '' desirability " is identical with 
what is usually called " utihty " in textbooks. " Desira- 
bihty " is preferred here as a better term to express the idea 
intended. If there exists a keen desire to purchase a cer- 
tain piece of land, we say that the land is especially desir- 
able. So, also, with sugar or any other commodity or bene- 
fit that is desirable. The desirability, then, of any particular 
goods, at any particular time, to any particular individual, 
under any particular conditions, is the strength or intensity 
of his desire for those goods at that time and under those con- 
ditions. 

The desirability of any particular goods may relate to the 
whole or to any part of a quantity of goods. The desira- 
bihty of the entire quantity is called the total desirability ; 
the desirabihty of one unit more or less of that quantity is 
called the marginal desirabihty. In economic science we 
have to do more with marginal than with total desirabihty, 
and it is therefore important that the concept of marginal 
desirabihty should be thoroughly understood. 

The marginal desirability of any good is the desirability of 
one unit more or less of it. If a person possesses ten chairs, 
their marginal desirabihty is the difference, in his mind, 
between the desirabihty of having ten chairs and the de- 
sirabihty of having nine chairs ; that is, it is the desirabihty 
which would be sacrificed by losing one chair. Or, what is 
almost the same thing, the marginal desirabihty of the group 



258 ELEMENTS OF ECONOMIC SCIENCE 

of ten chairs is the desirability of one chair more; that is, 
the difference in desirability between eleven chairs and ten. 

Whether the marginal desirability is taken as referring to 
one unit more or to one unit less is usually of so Httle im- 
portance as not to require separate designations to distin- 
guish them, and in case the good is one which admits of in- 
definite subdivision, as flour, wheat, coal, etc., the two tend 
to coalesce as the size of the unit is reduced. 

The total quantity of goods whose marginal desirabiHty 
is under consideration may be any specified quantity of 
goods whatever. It may be a specified quantity of goods 
now existing, or a specified quantity of goods in the future, 
or a specified flow of goods through a period of time. For 
instance, by the marginal desirabiHty of coal to an indi- 
vidual may be meant the marginal desirability of the par- 
ticular stock of coal in his bin at the present moment. If 
this stock consists of fifteen tons, its marginal desirabiHty 
is the desirabiHty of the fifteenth ton, or the difference to 
him between the desirabiHty of having fifteen and of hav- 
ing fourteen tons. Again, if a person is consuming in his 
household fifteen tons of coal a year, its marginal desira- 
biHty at any instant is the desirabiHty of the fifteenth ton, 
or the sacrifice which would be occasioned were he to re- 
duce his yearly consumption from fifteen tons to fourteen. 
It is therefore necessary in each case to specify the particular 
quantity of goods referred to. 

UndesirabiHty is the opposite of desirabiHty. Often 
we may express the same idea in terms of either word. For 
instance, it does not matter whether we speak of the de- 
sirability of keeping money, or the undesirabiHty of losing it. 

The first principle in regard to marginal desirabiHty is 
that an increase in the quantity of goods whose marginal 
desirabiHty is under consideration results in a decrease in 
the marginal desirabiHty. Each unit in addition is less 
desirable than the preceding unit. The marginal desira- 
biHty of sugar to the householder consuming five pounds 



THE INFLUENCES BEHIND DEMAND 259 

weekly is greater than the marginal desirabiHty to the 
same householder if six poimds are consmned, and is succes- 
sively diminished as each successive pound is added to his 
or her consimiption. 

It is well to remember that when the term '^ successively " 
is here used, it is metaphorically and not Hterally used. 
That is, the succession to which it refers is not a succession 
in fact, but a succession in thought. That is, we are con- 
sidering the consumer of sugar under a series of different 
hypotheses which we examine successively. We begin with 
the hypothesis of a weekly consumption of five pounds, and 
take up successively the hypotheses of six pounds, seven 
pounds, eight pounds, etc. The desirabiHty of the ^' last '' 
or '^ marginal " pound in this series is what we consider 
the marginal desirabiHty, but the '^ last " pound refers to 
the one considered last in our mental review, and not the one 
acquired last by the consumer. Marginal desirabiHty is 
usuaUy expressed as the desirabiHty of ''the last " unit. 
But by the "last" unit — say, the tenth chair — is not 
meant any particular chair of the ten, but merely the dif- 
ference between having nine chairs and ten chairs. This 
fact needs to be emphasized, in view of frequent confusion 
on the subject occasioned by too loose an employment of 
the words " last " and " successive." 

The total desirabiHty of any quantity of goods is the 
sum of the desirabiHties of the successive units. The total 
desirabiHty of the ten chairs, for instance, is found by 
adding together (i) the desirabiHty of having only one 
chair ; (2) the desirabiHty of having a second chair ; (3) 
of a third ; (4) of a fourth, etc., until ten chairs have been 
considered. 

In exactly the same way we may define the marginal de- 
sirabiHty of money. The marginal desirabiHty of money 
at any particular time, to any particular individual, under 
any particular conditions, has the same sort of meaning as 
the marginal desirabiHty of any other good. It is therefore 



26o ELEMENTS OE ECONOMIC SCIENCE 

the strength or intensity of a man's desire for the addi- 
tional dollar, or what amounts to the same thing, his reluct- 
ance to part with it. Briefly, the marginal desirabihty of 
money is the desirabihty of a dollar. Whenever he thinks 
of making a purchase, this desire comes into play, and the 
question of whether or not to buy is determined by his 
judgment as to whether or not the marginal desirability of 
the goods exceeds or not the marginal desirability of the 
price in nioney required to secure those goods. 

§ 3. Individual Demands derived from Marginal De- 
sirabilities 

It is on such comparison of the marginal desirabihties of 
goods and money that the demand curve of each individual 
depends. We shall now illustrate in detail how demand 
depends on desirability by taking the desires and demand 
of a given individual (whom we shall call No. I) for a given 
good (such as coal). We are to show that the price Indi- 
vidual I is willing to pay is simply the ratio between two 
marginal desirabilities, that of coal and that of money. 

If he thinks that one ton of coal is a dozen times as de- 
sirable to him as a dollar, he will evidently be willing to pay 
any price up to $12 for that ton. If the price is over ^12, 
he will not buy even a ton of coal. If it is just $12, he is will- 
ing to buy just one ton. A second ton will be worth, in his 
estimation, somewhat less, being, let us say, only ten times 
as desirable as a dollar. He will then be willing to pay up 
to $10 for this second ton. If the price is $10, he will buy up 
to two tons; for at that price it will evidently be more 
than worth his while to buy the first ton ^ndijust worth his 
while to buy the second. If the desirability of a third ton is 
eight times the desirabihty of a dollar, he will be wiUing to 
pay up to $8 per ton for three tons ; for at that price the 
first and second tons are more desirable than the money, and 
the third just as desirable. Likewise, if the desirabihty of 



THE INFLUENCES BEHIND DEMAND 



261 



the fourth ton is six times that of a dollar, he is willing to 
pay a price up to $6 per ton for four tons. 

In each case the highest price he is willing to pay for a 
given quantity is measured by the ratio of desirability of the 
last ton of that quantity to the desirability of a dollar. The 
consequent derivation of prices from desirabilities is sum- 
marized in the following table : — 



Tons Purchased 


Desirability or 

Each Successive 

Ton 


Desirability of 
A Dollar 


Price the Cus- 
tomer WOULD be 
willing to Pay 




{a) 


{a^b) 


I 


12 




$12 


2 


10 




10 


3 


8 




8 


4 


6 




6 


5 


5 




5 


6 


4 




4 



As indicated, the last column is found by taking the ratio 
of the figures in the first to those in the second ; i.e. dividing 
{a) by {b). As there are no standard units of desirability, 
it will not matter what unit we select. In the table, for 
simpHcity of division, we have taken as our unit for meas- 
uring desirability the marginal desirability of money of 
Individual I. We thus derive the individual's demand 
schedule from his schedules or desirabilities, which was our 
object. The resulting demand schedule is the fourth col- 
umn considered with respect to the first column. It tells 
us the highest prices (column 4) Individual No. I is willing 
to pay for stated quantities of coal (column i), or what 
amounts to the same thing, the largest quantities of coal he 
is willing to take at stated prices. As shown in the last 
chapter, it does not matter which way the relation is ex- 
pressed. 

In the preceding table the numbers expressing desira- 



262 



ELEMENTS OF ECONOMIC SCIENCE 



bilities and the numbers expressing price are the same be- 
cause we took the marginal desirability of money as our unit 
of desirabihty. It is sometimes said that price is merely 
the expression of marginal desirabihty ; i.e. that the price 
column merely duplicates the desirability column. But 
if we suppose another individual (No. II) who has precisely 
the same intensities of desire as No. I for coal, but who, 
on account of relative poverty, prizes each dollar twice as 
high, in comparing the two men we shall have to use the 
same unit of desirability, viz. the marginal desirability of 
money of Individual No. I. For Individual No. II the 
desirability of money is two such units. The result is the 
following table for Individual No. II : — 





1 
Tons Purchased 


Desirability of 

Each Successive 

Ton 


Desirability of 

A Dollar 

(b) 


Price the Cus- 
tomer WOULD BE 
willing to Pay 




(a) 


ia^b) 


I 


12 


2 


$6 


2 


10 


2 


5 


3 


8 


2 


4 


4 


6 


^ 2 


3 


5 


5 


2 


2.50 


6 


4 


2 


2 



The first ton has a desirability of 12 units just as did the 
first ton for Individual I, but the desirabihty of a dollar to 
Individual II is twice as great as that to Individual I, i.e. 
as two units of desirability. Hence the first ton, instead of 
being twelve times as desirable as a dollar, is only six times 
as desirable. Therefore he is willing to pay only up to $6 for 
it. The second ton, which has a desirability of ten units, is 
^Ye times as desirable as a dollar, and he is therefore willing 
to pay only up to $5 a ton for two tons. The price he is 
willing to pay for three tons is measured by the number of 
times the marginal desirability of money (2) is contained in 



THE INFLUENCES BEHIND DEMAND 263 

the marginal desirability of the third ton of coal (8) , which 
is four times — making the price $4. Likewise he is wilHng 
to pay 6 H- 2, or $3 a ton for four tons, and so on. Thus, 
just as in the case of Individual I, the prices in the last 
column are found by dividing the figures in the second col- 
umn by those in the third. But in this case the figures in 
the last column are not identical with those in the second 
column, but are only half as great. Thus, the higher the 
marginal desirability of money, the lower the price which 
buyers are wilhng to give. 

We see, then, that the two individuals, though they have 
precisely the same desires for coal, have very different de- 
mands for coal. If the price of coal is $5 a ton, Individual I 
will buy up to the fifth ton, for when he reaches the fifth 
ton, and not before, his marginal desirability of coal (5) 
will be just five times as desirable as a dollar (i). But at 
this same price of $5, Individual II will only buy up to two 
tons, for in his case I5 is the point at which the marginal 
desirabiHty of coal (10) is five times the marginal desira- 
bility of a dollar (2). This contrast interprets the fact that 
the poor '' cannot afford " to buy as much as the rich. 
The poor, like Individual II, have a relatively high marginal 
desirability of money. 

It is easy to express these same relations by curves. The 
demand curve is, as we know, merely a graphic picture of 
a demand schedule. We may Kkewise draw desirability 
curves as graphic pictures of desirabiHty schedules. And 
just as the demand schedule is derived by simple division 
from desirability schedules, so is the demand curve derived 
by simple division from desirabiHty curves. 

In Figure 29 the curve dd^ is the desirabiHty curve of coal 
for Individual No. I ; i.e. it represents the desirabiHty for 
him of each successive ton on coal as given in the preceding 
table. 

Thus the latitude or height (12) oi d represents the desir- 
ability of the first ton. The height (10) of the next point 



264 



ELEMENTS OF ECONOMIC SCIENCE 



T 


ds 
12 

m— 


\ 

10 


8 


6 


5 


-m' 
1 




1 


1 


1 


1 









2 : 


5 


^ 


^X 



to the right represents the desirability of the second ton, and 
so on to d\ the height (5) of which represents the desirabihty 

of the fifth ton. The de- 
sirabihty of the fifth ton is 
called the " marginal desir- 
abihty " of five tons, the 
desirabihty of the fourth 
the marginal desirabihty of 
four tons, etc. The lati- 
tude or height of each of 
the points from d to d^ 
represents the marginal de- 
sirability of the amount of 
coal corresponding to the 
longitude of that point. 
^^^- ^9. The heights of the points 

which form a horizontal row one unit above the base repre- 
sent the marginal desirabihty of money. From the heights 
of these two sets of points, — the upper ones representing 
the marginal desirabihty of coal and the lower ones repre- 
senting the marginal desirabihty of money, — by simple 
division of the numbers indicated, we derive the demand 
curve for Individual No. I. As the divisor is in this case 
unity, this dem.and curve 
so derived will coincide 
with the curve dd\ Hence 
dd^ will serve not only as 
the desirability curve for 
coal for Individual No. I, 
but also as the demand 
curve for Individual No. I. 
Figure 30 represents the 
corresponding curves for In- 
dividual No. II, for whom, 
by hypothesis, there are 
precisely the same marginal Fig. 30. 



Y 


r^ 


N^ 














12 '\ 


















d. 


6^^-^. 


5---.^ 


6'\ 


6 '"- 


I'' 




m- 








3'— > 


-d 




2 


2 


2. 


2 


2 









2 : 


3 ^ 


1- £ 


5 X 



THE INFLUENCES BEHIND DEMAND 265 

desirabilities of coal, but for whom the marginal desirability 
of money is twice as great. The upper points ;- to / repre- 
sent the marginal desirability of coal, and are at the same 
heights as the upper points d to d^ in Figure 29. The lower 
points in Figure 30, however, are now two units high instead 
of one. Hence, when we divide the numbers 12, etc., for 
r/ by the number 2, we shall get as our demand curve a 
curve dd\ which, unlike the demand curve for Individual I, 
will not coincide with rr', but will be everywhere only half 
as high. 

We see, then, how to derive an individual demand schedule 
(or curve) by dividing, so to speak, one desirabiHty schedule 
(or curve) by another. The resulting dem^and schedule (or 
curve) of coal will coincide with the schedule (or curve) of 
marginal desirabiHty of coal if the marginal desirability of 
money be taken as the unit. Otherwise the demand sched- 
ule (or curve) will have its figures all standing in a given 
ratio to those of the schedule (or curve) of marginal desir- 
ability of coal. 

In the last chapter we considered the price of coal as the 
effect of supply and demand and expressed by two curves. 
In this chapter we have seen that one of these two curves, 
the demand curve, is in turn the effect of innumerable in- 
dividual demand curves; and finally, that each of these 
individual demand curves is in turn the effect of two de- 
sirabihty curves for the given individual. These desira- 
biHty curves are the ultimate curves lying back of demand. 

This is all true on the assumption that the marginal de- 
sirability of money for each individual remains constant, as 
represented in our tables or curves, being always i for In- 
dividual I and always 2 for Individual II. In other words, 
we have assumed that the marginal desirability of money is 
not appreciably affected by a large or small purchase of coal. 
Of course a purchase might be made so large or at so high 
a price that the marginal desirabiHty of money would be 
appreciably affected. Theoretically, the marginal desira- 



266 ELEMENTS OF ECONOMIC SCIENCE 

bility of money increases with every expenditure ; the less 
money there is left, the more precious it becomes. But there 
are so many ways to spend money, and the expenditure on 
any one thing, such as coal, requires so small a drain on 
the total power to spend that the marginal desirability of 
money is not very different whether a man buys no coal at 
all or all he can afford. Consequently for the same indi- 
vidual, the desirability of a dollar may be regarded as a 
constant quantity represented, as in Figures 29 and 30, by 
the heights of a horizontal row of points. 

§ 4. Relation of Market Price to Desirability 

We shall now show that the market price of coal, although 
it is itself the ratio between two physical things, — the 
ratio of a quantity of money to a quantity of coal, — is, 
nevertheless, equal to the ratio between two intensities of 
desire in the mind of each purchaser — the ratio of the 
marginal desirability of coal to that of money. No indi- 
vidual demander of coal can, of course, determine the market 
price of coal. On the contrary, to him the market price 
seems to be fixed, and all that he can do is to adjust his 
purchase to it. But this adjustment, when practiced by all 
the numerous persons who demand coal, constitutes the 
whole demand side of the market, and exerts, therefore, a very 
powerful influence on price. Market price, we have seen, 
must '' clear the market," and, applied to the demand side 
of the market, this means that the market price must be 
such that when each individual on the demand side adjusts 
his purchase to it in such a manner that the ratio of his 
marginal desirabihty of coal to his marginal desirability of 
money is equal to the price, the sum total of all such 
purchases {i.e. the total demand) shall equal the total 
supply. 

This principle that the market price of any good is equal 
to the ratio between its marginal desirability and the mar- 



THE INFLUENCES BEHIND DEMAND 267 

ginal desirabiKty of money is so important that it will be 
advisable to restate it in as many forms as possible. 

We may state the stopping point of each purchaser in 
any one of the following ways : — 

1. Each purchaser buys until the ratio between the de- 
sirabihty of the marginal unit and the desirability of the 
dollar is reduced to equality with the price. 

2. Each purchaser buys until the desirability of the mar- 
ginal unit is reduced to equahty with the desirabiUty of the 
money spent for them. 

3. Each purchaser buys until his marginal gain (of 
desirabihty) is reduced to nothing. 

4. Each purchaser buys until he makes his gain (or sur- 
plus desirabihty) a maximum. 

The last two may require further explanation. 

Evidently it is the same thing to say that a purchaser stops 
buying when the desirabihty of the last ton is equal to the 
desirability of the money paid for it, as to say that he stops 
buying when the last ton has no excess of desirabihty over 
the desirability of the money paid for it. 

Let us examine the nature of the gain which the purchaser 
makes, and which is thus reduced to zero on the last ton. 
Evidently he gains no money ; on the contrary, he loses it. 
What he does gain is desirability. His gain in desirability or 
his surplus desirabihty is the difference between the total de- 
sirability of the coal he buys and the total desirability of the 
money he has to sacrifice. 

If the price is $5 per ton, in which case Individual I, as 
his schedule (or curve) shows, buys 5 tons, the total desir- 
abihty of these 5 tons to him is 41 units of desirabihty, being 
the sum of the desirabilities as given in the schedule (or 
curve) for these 5 consecutive tons, viz. 12-f 10 + 8 + 6 
+ 5 ; the sacrificed desirability is the desirabihty of the $25 
spent, which, as we assume that each dollar has i unit of 
desirabihty, is 25 units; the surplus desirabihty is the ex- 
cess of the total over the sacrificed desirability, or 41 — 25 



268 ELEMENTS OF ECONOMIC SCIENCE 

= i6 units. Now this gain of i6 consists of a diminishing 
gain on successive tons. On the first ton the gain is the 
difference between the 12 units which the ton is worth and 
the 5 units he must sacrifice to get it. This is 12 — 5 or 7 
units; likewise the gain on the second ton is 10 — 5 = 5 
units ; on the third, 8 — 5 = 3 units ; on the fourth, 6—5 
= I unit ; and on the fifth, 5 — 5 or zero. He stops his pur- 
chase at this point, for if he should extend it farther, he 
would lose desirability. The sixth ton, for instance, would 
yield only 4 units and cost him 5, and the seventh and later 
tons would cause greater losses. 

Likewise for Individual II, who can only afford to buy 
2 tons, the total desirability is 12 + 10 = 22 units of 
desirabiHty ; the sacrificed desirability is the desirability of 
the $10 paid, which, as each dollar is supposed to have 2 
units of desirability, is 20 units ; and the surplus desira- 
bility is 22 — 20 or 2 units. This gain is all on the first ton, as 
the second is only just worth its cost. 

Individual I thus gains more than Individual II, though 
both gain something. 

Still another method of stating the principle is that each 
buys so as to make the greatest possible gain of desirabihty. 
Evidently Individual No. I gets his greatest gain by buying 
5 tons. His gains on these 5 tons were respectively 7, 
5, 3, 1, and o units, making, as we have seen, an aggregate 
gain of 7 + 5 + 3 + 1 + or 16 units. Had he stopped 
buying at the third ton, his gain would have been i unit 
less or 15 units. On the other hand, if he had bought 6 
tons, he would have lost i unit on the sixth ton, which 
would have reduced his gain from 16 to 15. Thus by stop- 
ping at the fifth ton he gains the most he can. 

The idea of something, not money, gained in a trade is 
important to grasp. By its aid we have no difficulty in 
understanding that both parties normally gain by a trade. 
Trade does not imply that one of the two parties gains at 
the expense of the other. This is true when one of the two 



THE INFLUENCES BEHIND DEMAND 269 

parties cheats the other, but normal trade is not cheating. 
Nevertheless, the idea that only one party can gain by a 
trade is an old and persistent one. It was largely respon- 
sible for attempts to regulate prices in the Middle Ages, to 
make the price " just " and prevent one party gaining at 
the expense of the other; it was also largely responsible 
for the sentiment in favor of encouraging the export trade 
but discouraging the import trade, a practice which implied 
that a nation was winning when it sold more than it bought, 
but losing when it bought more than it sold. In fact, the 
phrases " favorable balance of trade " and " unfavorable 
balance of trade," based on this idea, are still in use, although 
their original imphcation of gain or loss is gone. We now 
recognize that the country parting with money by buying 
goods from abroad may gain desirability just as the man 
who parts with money by buying coal gains desirability. 

The idea of total desirabihty, as contrasted with marginal 
desirability, will serve to explain the old paradox that the 
most desirable things are not the highest in price. Nothing is 
so indispensable to us all as the air we breathe, yet its price 
is zero. The reason is now clear. Air is so abundant that 
the marginal desirability of air — the desirabihty of one 
additional cubic foot — is nothing at all, although the total 
desirability of air is great. An example of the opposite 
kind is found in jewelry. As compared with air, gold ear- 
rings have far less total desirability but far more marginal 
desirability. As the price depends on the marginal desira- 
bility, and has no reference to total desirabihty, we have no 
difficulty in reconciling the fact that earrings are worth more 
than air with the fact that air is more desirable than earrings. 

§ 5. Importance of the Marginal Desirability of Money 

The student will have noticed that the money element was 
present in all the stages of our study, and is still present even 
when we carry our analysis down to each individual mind. 



270 ELEMENTS OF ECONOMIC SCIENCE 

A halving of the purchasing power of money halves its 
marginal desirability to each person. But as we have seen 
in desirabihty schedules (and curves) of Individuals I and 
II, the marginal desirabihty of any individual is a divisor to 
be divided into the marginal desirability of coal to give the 
price the individual is willing to pay for coal. Therefore 
to halve this divisor for each individual will result in doub- 
Hng the quotient — the price he is wilhng to pay. In other 
words, the prices in each individual's demand schedule 
(or curve) will all be doubled by halving the purchasing 
power of money. Consequently the same is true of the 
total demand schedule (or curve) . This is merely restating 
what has been said before, except that now we trace back 
the effects of a change in the purchasing power of money 
to each individual on the demand side of the market. 

We can now see more clearly than in Chapter I how care- 
ful we should be when measuring values in terms of money. 
If our object is to compare desirabilities, we must correct 
our money comparisons for differences in the desirabihty 
of money. We must make allowance for differences in the 
importance of a dollar (i) between different people according 
to differences in wealth and needs, and (2) between different 
times or countries according to differences in price level. 

(i) As to corrections between different people, if a mil- 
lionaire's wife pays $10,000 for a brooch, while her poor 
neighbor pays $10 for a gown, we should not infer that the 
rich woman prizes her brooch a thousand times as much 
as the poor woman prizes her gown. This would be true if 
the desirabihty of a dollar were the same in the two cases, 
but as it is likely that the poorer woman prizes a dollar more 
than a thousand times as highly as the richer woman, it is 
altogether probable that the gown is of more importance 
to the poor woman than the brooch is to the rich one. Yet 
in money the brooch is worth a thousand times the gown. 

From the fact that the richer an individual is, the less his 
or her marginal desirabihty of money, it further follows that 



THE INFLUENCES BEHIND DEMAND 



271 



the comparative desirability of two fortunes is much less 
than their money values would suggest. A man whose 
income has increased from $1000 to $10,000 a year is better 
off than when it was $1000 a year, but he is not ten times 
as well off. The extra $9000 may not be worth as much as 
the original $1000, in which case he is not even twice as well 
off. It is still truer that a man with a fortune of $500,000,000 
is only slightly better off (if at all) than one with only 
$1,000,000. Were these facts better appreciated, '' great 
riches," though desirable, would be less dazzling to those 
who have never possessed them. 



♦ 1000 




Fig. 33 



Figure 31, in which longitude represents income, and 
latitude its marginal desirability, expresses the fact that 
the marginal desirability of money (assuming a given pur- 
chasing power) decreases very rapidly with an increase in 
income ; that is, the richer a person, the less — and very 
much less — he prizes an individual dollar. The curve 
probably continues to the right indefinitely, though grow- 
ing closer and closer to the base ; that is, no matter how rich 
a man becomes, an additional dollar will still have some 
desirability in his eyes. Man is literally insatiable. 



272 ELEMENTS OF ECONOMIC SCIENCE 

(2) As to corrections between different price levels, we 
note that money wages in the United States are higher 
than in England; but it is misleading to make any com- 
parisons unless we first correct for differences in the price 
levels or purchasing power of money. In some occupations 
it would seem that the difference in wages only just corre- 
sponds to the difference in the purchasing power of money, 
so that in those cases the American workman is really no 
better off than the English. He has more money wages, 
but its marginal desirabihty is so much less that he has 
no more desirable food, lodging, or comforts. In general, 
however, after all allowances are made for difference in 
price levels, the lot of the American workman is usually 
better than that of the EngHsh. 

Desirabihty is, therefore, a far more fundamental con- 
cept than mere money value. This could not fail to be 
recognized if we had any practical means of measuring 
desirabihty. Unfortunately, as yet, we have no such means. 
As money values are usually measurable, we are often com- 
pelled to make our measurements in money or else make 
none at all. This must not, however, mislead us into at- 
tributing to money measures any greater significance than 
they actually possess. 



CHAPTER XVII 



INFLUENCES BEHIND SUPPLY 



§ I. Analogies between Supply and Demand 

In the last chapter we have seen that a total demand 
schedule (or curve) for any particular good is derived from 
innumerable individual demand schedules (or curves), and 
that each individual demand schedule (or curve) is derived 
from a pair of desirabihty schedules (or curves) , one relating 
to the marginal desirability of the particular good under 
consideration and the other relating to the marginal desir- 
ability of money. 

With certain exceptions to be explained later, precisely 
these same propositions are true of the supply side of the 
market. 

First of all, then, the total supply at any price is merely 
the sum of the individual supplies at that price, as illus- 
trated in the following '' supply schedules " for coal for two 
individuals. As before, we distinguish them as I and II 
(without meaning to imply, of course, that they are the same 
individuals as those called I and II in Chapter XVI). 





Supply Schedules. Tons which 

WOULD BE supplied BY INDIVIDUALS 


Total 
(a + b) 


Price 


I 

(a) 


II 

(b) 


$4 
5 
6 

7 


1500 
1600 
1800 
2100 


2000 
2400 
3000 
3900 


3500 
4000 
4800 
6000 



273 



274 ELEMENTS OF ECONOMIC SCIENCE 

The last column gives the sum of the figures in the first 
two. If we should include in our table all suppKes in the 
market, we should obtain in this way the total supply sched- 
ule. The same relations are indicated graphically in Figure 
32, where s^ s\ is the supply curve for coal of Individual I, 
i.e. a curve such that if the latitude of any point on it rep- 
resents a given price, the longitude of that point will repre- 
sent the amoimt of coal the individual is willing to supply 

at that price. Similarly, let 
^2 s^2 ^^ ^^ supply for coal 
of Individual 11. If, as in 
the case of demand curves, 
we add longitudes {e.g. Sy = 
s-^y + sy)<^ we obtain SS^ as 
the curve representing the 
total supply of both individ- 
uals. 

If in like manner we add 
together all the individual 
^^' ^^' curves of all the individuals 

in the market, we obtain the total supply curve of the market. 
Having thus derived the total supply schedule (or curve) 
from its constituent individual supply schedules (or curves), 
we next seek, as in the case of demand schedules (or curves), 
to derive each individual schedule (or curve) from a pair of 
desirability schedules (or curves). 

The following table illustrates such a derivation. The 
figures in the last column, found from the other two by 
simple division, gives the prices a coal dealer would be will- 
ing to take in view of the desirabihty to him of the money 
he seeks to get by selling coal and the undesirabihty of the 
trouble and expense involved in getting it. If the 1500th 
ton costs him 8 units of desirability, and a dollar repre- 
sents to him 2 units of desirabihty, he will evidently be 
wilhng to take $4 a ton up to the 1500th ton, and so on 
for the other figures in the table. 




INFLUENCES BEHIND SUPPLIES 



275 





UNDESmABILITY OF 


Desirability of 


Price the Dealer 


Tons Sold 


SUPPLYING Last 
Ton 


A DOLL.AR 

ib) 


would be willing 
TO Take 




(a) 


(a-i-b) 


1500 


8 


2 


$4 


1600 


10 


2 


5 


1800 


12 


2 


6 


2100 


14 


2 


7 



The same relations may, of course, be represented graph- 
ically. In Figure 33, the latitudes of the points on the 
line, r/, represent the undesirabihty per ton of parting with 
the coal, and those of the lower line mm^ represent the 
desirabihty per dollar of obtaining money. The result 
of dividing the latitudes of ^- 

the points of r/ by those of Y 
mni (i.e. 2) gives us the 
supply curve ss\ the height 
of which at different points 
will be proportional to 
those of the curve r/. The 
latitude of the curve r/ rep- 
resents the undesirabihty 
of the efforts and sacrifices 
of furnishing each succes- 



" marginal 






X 



Fig. 33- 



sive unit, or 
undesirabihty," and the 
latitude of the curve ss^ represents this marginal unde- 
sir ability translated into money. This marginal undesira- 
rability translated into money is usually referred to briefly 
as marginal cost of production or simply as marginal cost. 
It comprises everything undesirable involved in supplying 
the article under consideration, including all discounted 
future costs, the money equivalent of all labor and trouble, 
as well as all actual money expenses. The seller is more 



276 ELEMENTS OF ECONOMIC SCIENCE 

apt to think and talk in terms of money than the buyer, for 
the seller as such has more to do with money. Unless he is 
a mere workman, the only cost to whom is labor cost, most 
of his costs are in the form of money expenses. 

§ 2. Principle of Marginal Cost 

Hitherto we have treated the marginal desirability curve 
for money as a horizontal straight line. This was essentially 
true for the purchaser, but for the seller it is untrue. For 
the purchaser, money performs many offices besides buying 
coal, and its importance for the purchase of coal is not great. 
To the coal dealer, however, coal is the only thing he sells 
for money. To him, therefore, changes in the. amount of 
coal sold and the price of coal will make a great difference 
to the total amount of money he gets and therefore to its 
marginal desirability. If, for instance, the price of coal 
changes a dollar a ton, though to the purchaser this fact 
will not appreciably affect the marginal desirability of 
money, to the seller it may make all the difference between 
poverty and affluence. 

Consequently, in treating supply, we cannot continue to 
assume that the marginal desirability of money remains 
constant and can be represented by a horizontal straight 
line. Instead, the marginal desirability of money decreases 
the greater the sales, and therefore the more money is ob- 
tained. Consequently the line mm)', representing marginal 
desirability of money, should descend to the right as the 
sales increase. Moreover, the descent of this curve mm^ 
will depend on the price, so that we cannot even construct 
it until we specify a particular price. In Figure 34 these 
facts are taken into account, OP represents the assumed 
price, the curve rr , as before, represents marginal unde- 
sirability of furnishing coal, and the descending curve 
mm' represents the marginal desirability of the money 
obtained. We now use these two curves just as we did 



INFLUENCES BEHIND SUPPLIES 



277 



those in Figure 33, and obtain the point s, the latitude of 
which is the assumed price OP, and the longitude the supply 
of the individual at that price. By changing OP and repeat- 
ing the construction, we can obtain other points than 5, 
thus constructing the supply curve showing the marginal 
cost of supplying different amounts of coal. 

In the supply curve, as we have just constructed it, the 
price is a minimum relatively to the supply, and the supply 
a maximum relatively 
to the price ; that is, 
the curve shows the 
lowest prices at which 
given amounts will be 
suppHed, or the great- 
est amounts which 
will be supplied at 
given prices. 

We see, then, that 
the total supply curve, 
analogously to the 
total demand curve, 
may be derived from 
a number of individual supply curves, and that each such 
individual supply curve may be derived by assuming suc- 
cessive prices, and for each price constructing (i) a curve of 
marginal undesirabihty of furnishing the article and (2) a 
descending curve of marginal desirability of money. 

The important result is that the market price, as finally 
determined by supply and demand, is not only equal to the 
marginal desirabihty of getting coal for each buyer, but 
also to the marginal undesirability of furnishing it for each 
seller, both the desirabilities and undesirabilities being 
measured in terms of money. 

Thus, if the price of coal is $5 a ton, the last ton bought by 
each buyer is worth barely $5 to him, while the last ton sold 
by each seller costs him about $5 worth of expensejand trouble. 

















.-r- 


Y 






., • 










. • -' 


r?,-' 








r 


















fi 








y 







s 


,-' 






















0' 










m 






--- 


m" 















..rrf 





1000 


1000 


1000' 


Sooo 


1000 


1000 


X 



Fig. 34. 



278 ELEMENTS OF ECONOMIC SCIENCE 

These equalities on the margin of all sales and purchases, 
and the fact that the price must be such as will equalize 
supply and demand, i.e. " clear the market, ^^ are the funda- 
mental principles which determine the market price of any 
particular good. 

Market price, then, is such a price as will equalize (in 
terms of money) all marginal desirabilities of buyers and 
all marginal undesirabilities of sellers, and at the same time 
equalize the total demand of all the buyers with the total 
supply of all the sellers. In short, market price results 
from the following two principles : — 

(i) The equalization of all marginal desirabilities and 
undesirabilities (measured in money). 

(2) The equalization of supply and demand. 
We cannot neglect either of these two principles, nor can 
we omit either half of the first principle. It is a mistake 
to think that price can be determined by marginal desira- 
biHty alone or by marginal undesirabiiity alone. It takes 
two sides to make a bargain and a market price. The 
present chapter, however, is especially devoted to the 
supply side. 

On the supply side of the market, therefore, the great 
determinant of market price (in terms of money) is mar- 
ginal cost (in terms of money). 

The same principle would, of course, apply in terms of any 
other good than money or in terms of general purchasing 
power. We have already had occasion to anticipate this 
principle when considering the production and consumption 
of gold and silver. The price or purchasing power of gold, 
we found, depends not only on gold as money, but also on 
gold as a commodity. In the latter case its supply and 
demand needs to be considered like those of any other com- 
modity. That is, so far as gold is an individual commodity 
like silver or coal, the study of its price or purchasing power 
involves the principles which determine an individual price 
as well as the principles which determine the general level 



INFLUENCES BEHIND SUPPLIES 279 

of prices. Our present study of individual prices, therefore, 
throws Hght on our previous study of gold. If the student 
will return for a moment to Figures 10-13, ^^ will see that 
the distance below the line 00 of the highest outlet (in oper- 
ation) from any bullion reservoir is simply what we would 
now call the marginal desirability of gold for use in the 
arts (measured in terms of general purchasing power over 
goods), and that the distance of the lowest inlet (in oper- 
ation) is the marginal cost of production of gold (measured 
likewise in terms of general purchasing power over goods). 
We may now add that the differences in costs of producing 
gold, represented by the differences in heights of the inlets, 
are not altogether due to differences between mines, but 
also to differences in working the same mine. There is 
a marginal cost of production for each mine. The higher 
the speed of extracting, the higher the cost per ounce. 
This is called the law of increasing cost (per unit of prod- 
uct) or of diminishing returns (per unit of cost). It applies, 
of course, more generally than simply to gold and silver. We 
have taken coal as our typical example. We might have 
taken numerous other examples. If the price of wheat rises, 
its marginal cost will rise. Worse lands will be resorted to, 
and lands previously under cultivation will be worked more 
intensively until, on all wheat lands the cost (measured in 
money) of furnishing an additional bushel will be equal to 
the price. 

§ 3. Upward Supply Curves which turn Back 

In spite of the analogies we have noted between the 
supply and the demand side of the market, the differences 
between them are so great and important that the rest of 
this chapter will be devoted to them. 

All demand curves descend to the right, and we have 
hitherto assumed that all supply curves ascend to the right. 
But not all supply curves do ascend to the right. One 



28o ELEMENTS OE ECONOMIC SCIENCE 

pecuKar type of supply curve grows out of the fact recently 
noted, that there is a separate and descending curve of 
marginal desirability of money. This fact, when combined 
with the ascending curve of desirabihty of coal, tends to 
bend the supply curve upward — sometimes so much as 
to cause it to curl back to the left, as in Figure 35. Such a 
curve, although it ascends, does not, throughout its course, 



Y 




ascend to the right. It appHes 
especially to the supply of labor. 
The meaning of such a supply 
curve is that a rise of price does 
not always cause an increased 
supply. At first it does, but be- 
yond the point where the curve 
begins to curl back a rise of price 
evidently results in reducing the 

supply. 

-^ If we stop to consider the mo- 
^^* ^^* tives of a workingman, we shall 

see that this is true of him. If wages are low, a rise in 
them will at first stimulate the workman to work longer 
hours, but after a certain point he will prefer to rest on his 
oars. He earns so much in a few hours that he feels it is 
no longer necessary to work so hard. In South America, 
for instance, traders from Europe were once buying native- 
made baskets of a peculiar kind. In order to increase the 
supply of baskets, which was far less than they could mar- 
ket in Europe, the traders decided to raise the price that 
they would offer to the makers, thinking thereby to stimu- 
late the production of baskets. Exactly the opposite 
result followed. As soon as these workmen were offered 
high prices for the baskets, they produced less than before ; 
they could now get more money even for doing less work, 
and they didn't need or want more. Their wants were so 
few and simple that their marginal desirability of money 
decreased very rapidly with an increased amount of it. 



INFLUENCES BEHIND SUPPLIES 281 

That is, as the price rose from the height of / to that of s^\ 
the supply decreased from the longitude of / to the longi- 
tude of s^\ In the same way in the Philippine Islands it 
has been found that to raise the wages of workmen some- 
times resulted in their working less hours in the day and 
less days in the year. One Spaniard, in order to keep his 
foreman, whom he considered very efficient, gave him a par- 
ticularly high salary. The plan worked well for a few 
months, but at the end of that time the man had accumu- 
lated so much money that he had little desire for more, and 
decided to retire. Now this same principle applies to all 
labor. Experience indicates that as wages go up workmen 
demand shorter hours. The eight-hour movement of to-day 
is at bottom due to the fact that wages are high. When 
wages were low, men worked twelve hours a day; now 
that they are high, they work only ten, nine, or even eight, 
hours a day. The same principle explains why men with 
the highest salaries, instead of working longer hours than 
others, usually work shorter hours. The most highly 
paid grades work the fewest hours and take the longest 
vacations. 

The exact point in wages at which the curve begins to 
bend back so that if wages are raised any higher the supply 
of work will diminish, depends on the particular conditions 
in each case, the size of the workman's family, the range 
and character of their wants or their *' standard of living,'' 
and other similar conditions. The more wants a man has, 
the higher the point the curve begins to bend back, i.e. the 
less easily is he satisfied with more money. A curious in- 
stance in the Philippines is that workmen who have a taste 
for alcohol are sometimes more useful to their employers 
than those who are always sober, because those who want 
liquor have a larger range of desires and are therefore apt to 
work harder in order to get the drinkables they desire; 
whereas the sober man is contented merely to get enough 
food to eat, and will work only just long enough for that pur- 



282 ELEMENTS OF ECONOMIC SCIENCE 

pose. A relatively slight rise of wages satisfies his wants 
so completely or so nearly completely that he does not 
consider any further wages worth the effort. 

§ 4. Downward Supply Curves 

The typical supply curve, with which we began, ascends 
continually to the right. In the exceptional case just con- 
sidered, the rightward movement was arrested and turned 
into a leftward movement. Our next exceptional case is 
that in which the curve does not even ascend, but descends. 
Such descending supply curves are common under modern 
conditions of factory production. It is often found that a 
large product costs less trouble, per unit, than a small prod- 
uct. This is due to the fact that, in such cases, the mar- 
ginal undesirability of furnishing the good decreases with 
an increase of supply, and not only decreases, but decreases 
in a faster ratio than does the marginal desirability of money ; 
so that the ratio of the one to the other, i.e. the marginal 
cost, decreases with an increase of supply. 

When marginal cost decreases with an increase of supply, 
the supply schedule (or curve) is no longer the schedule (or 
curve) of marginal costs, but must be constructed on an en- 
tirely new principle. The principle that market price is 
equal to marginal cost will no longer hold true. Only when 
the supply curve ascends will it be true that the price at 
which the seller is willing to supply a given amount is equal 
to its marginal cost, and is therefore derived from the curves 
of undesirabihty. Descending supply curves are derived 
entirely differently. They depend not on marginal cost 
at all, but on average cost. The reason is that no seller is 
willing to sell at a loss, and this is what he would be doing 
if he should offer to sell at prices corresponding to marginal 
cost when the marginal cost decreases with the amount 
sold. It is clear that, if the cost of supplying the 3000th 
ton of coal is $5, and the cost of all preceding tons is greater 



INFLUENCES BEHIND SUPPLIES 283 

than $5, not even one ton of coal could be sold at $5 a ton 
without a loss, and if 3000 tons were sold at that price there 
would be a loss on every ton except the last. Rather than 
sell 3000 tons or any less number at $5 a ton, the dealer 
would choose to sell none at all. Contrast this result with 
that which obtains in the case of an ascending curve. In 
this case the cost of supplying the 3000th ton was $5, but 
the cost of all preceding tons was less than $5, so that in- 
stead of a loss there was a profit on each of these preceding 
tons. Not only could he afford at $5 to sell 3000, but this 
amount gives him the maximum profit — more, for instance, 
than if he should sell 2000 or 4000 tons. In order that any 
dealer shall sell at all, he must expect to get back at least 
the total cost. This means that he must therefore charge a 
price at least as high as the average cost per ton. When the 
cost of each successive ton is greater than that of the preced- 
ing ton, the cost of the last, or marginal cost, is the greatest 
cost of all, and therefore exceeds the average cost. Conse- 
quently the dealer was assured a profit when selling at a 
price equal to the marginal cost. But when the cost of each 
successive ton is less than that of the preceding ton, the cost 
of the last (marginal cost) is the least of all, and therefore is 
less than the average cost. 

In either case, then, the seller must get back at least the 
average cost and also at least the marginal cost. In short, 
he must get a price at least as high as the higher of the two. 
Whichever of the two is the higher will show itself in 
the supply curve. When the marginal cost increases with 
supply, marginal cost is the higher, and will rule supply. 
When the opposite is true, average cost is the higher, and 
will rule supply. 

In the latter case the supply schedule (or curve) is a 
schedule (or curve) of average costs. We need not describe 
in detail how to construct such a schedule (or curve) . This 
presents no difficulty, since we already know how to con- 
struct a schedule (or curve) of marginal costs which gives 



284 ELEMENTS OF ECONOMIC SCIENCE 

the individual costs of each separate ton. The simple 
average of any specified number of these is the average cost 
of that number. 



§ 5. Resulting Cutthroat Competition 

But, besides the fact that the ascending supply schedules 
(or curves) are based on marginal costs, and descending 
supply schedules (or curves) are based on average costs, 
the two types of supply curves offer another and even more 
important point of contrast. The supply at a price is in 
the first case the maximum which the seller is willing to offer 
at that price, whereas in the second case it is the minimum. 
When we consider simply ascending types of supply, we 
may express the relation between the price and supply in 
two ways, either — 

(i) Given the supply, the price is the minimum price at 
which that supply will be offered ; or 

(2) Given the price, the supply is the maximum which will 
be offered at that price. 

The first of these two propositions still holds true when 
the supply descends instead of ascends; but the second 
will not hold true until we have changed the word " maxi- 
mum" to ^' minimum." In other words, when, as originally 
supposed, the supply ascends, the seller is willing at any 
given price to supply a certain maximum amount or less; 
while, when the supply descends, he is willing at any 
given price to supply a certain minimum amount or more. 
In this respect, then, supply and demand are not an- 
alogous. 

In the case of demand there were not two classes, one 
ascending and the other descending, but only one. In all 
cases demand decreases as price increases. Consequently 
there were not two ways of stating the relation between 
price and demand. The amount demanded at a price is 
always the maximum amount which will be taken at that 



INFLUENCES BEHIND SUPPLIES 



28s 



price; and the price is the maximum price which can be 
gotten for that amount. 

Let us then summarize our results, expressing each on 
he basis of a given price. 

1. At a given price, each buyer is wilhng to take a certain 

maximum amount or less at that price. 

2. At a given price, each seller is willing 

{a) (in case marginal cost increases with an increase 
of supply) to offer a certain maximum amount 
or less at that price. 

{h) (in case marginal cost decreases with an increase 
of supply) to offer a certain minimum amount 
or more at that price. 
The contrast between the two types of supply are illus- 
trated graphically in Figures 36 and 37. Figure 36 illus- 
trates case a and Figure 37, 
case h. The curve in the first 
case is seen to be the maximum 
limit of longitude, and in the 
second case the minimum limit. 
The longitude of any point in 
the shaded area represents an 
amount which the seller is will- 
ing to supply at the price cor- 
responding to the latitude of 
that point. Thus, if we take 
any horizontal line in the 
shaded area of Figure 36, its 
latitude represents an assumed price, at which the seller is 
wilhng to supply any amount, from nothing at the left end 
of the hne to the maximum amount at the right end where 
the horizontal line is limited by the curve. Taking any 
horizontal hne in the shaded area of Figure 37, the seller is 
willing to supply any amount from the minimum at the 
curve, i.e. at the left end of the hne, up to an indefinite 
amount at the right. 




Fig. 36. 



286 



ELEMENTS OF ECONOMIC SCIENCE 




In the latter case, i.e. when the cost of each additional unit 
of product is less than that of the preceding unit, the more 
the seller can sell the better he likes it. If he sells only the 

minimum, he gets back 
only his average cost of 
production, and makes no 
profit. Any sales beyond 
this bring him a profit, 
and the larger the sales, 
the larger the profit. 

This fact introduces us 
to an unexpected conclu- 
sion, viz. that if the total 
supply curve descends, the 
price represented at the 
^^^' ^^' intersection of the supply 

and demand curves, although it clears the market, is not a 
stable price, but tends always to fall. Whether the price 
is above, at, or below, the latitude of the intersection, it will 
tend to fall so long as the y 
supply curve descends. 
Let us consider each case 
separately. If the price 
(Fig. 38) is OP, higher 
than the intersection, the 
demand exceeds the mini- 
mum supply and stimu- 
lates each suppher to 
furnish more than his min- 
imum, which, of course, 
he is only too glad to do. 
Consequently, the supply 
will soon overtake demand 




Fig. 38. 



Those competing to supply 
will strive to underbid each other, and the price will fall. 

But it will not stop falling at the intersection. Suppose it 
is below, as at OP', it will continue to fall. For then even 



INFLUENCES BEHIND SUPPLIES 287 

the minimum supply exceeds the demand, and all who com- 
pete to supply will be very eager not to be left with unsold 
goods on their hands. A rise of price would, it is true, 
remedy the difficulty. But no individual can apply this 
remedy, and there is, by hypothesis, no combination. 
The individual competitor cannot raise prices without secur- 
ing the agreement of others ; but to do this would be to create 
a combination which is contrary to our present hypothesis 
of independent action. If he should individually raise his 
price, he would be committing commercial suicide, for no 
people would buy of him when they could buy more cheaply 
of his competitors. His only hope of achieving his purpose 
of increased sales hes in adopting the opposite course, and 
underselKng his competitors regardless of the consequences 
to them and to the market price. He hopes that, before 
they can meet his cut in price, he may win the patronage 
he needs to make it worth his while to stay in the market, 
and that he may thus drive some of his competitors out of 
business. If he fails to get the needed patronage, he must 
go out of business himself. He therefore offers his wares 
at a price below 0P\ But, as we have seen, there cannot 
be two prices in the same market at the same time. Hence 
all his competitors must reduce their prices, to his. 

Whatever the effect of this action may be on the individual 
who first cuts the price, the result on the whole is evidently 
to make matters worse ; for, according to conditions shown 
in the diagram, the lower the price, the more will the supply 
exceed the demand. 

We have here what is known as '' cutthroat competition " 
or a '' rate war," i.e. competition the effect of which is not 
simply to reduce profits but to create losses. 

§ 6. Resulting Tendency toward Monopoly 

But we have not yet reached the ultimate result of such 
competition. Some competitors must sooner or later see 



288 ELEMENTS OF ECONOMIC SCIENCE 

that there is no hope to secure the large sales necessary 
to make business worth while. They withdraw. This re- 
duces the losses for the rest ; for, by removing their supply 
curves, the total supply curve is reduced in longitude, and 
the discrepancy between supply and demand is lessened if 
not done away with entirely. But even so, the tendency 
of the price to fall is not hindered, for we have seen that, as 
long as the supply curve decreases, competition forces the 
prices down on whatever side of the intersection the price 
may be. In the case of a descending supply curve, the in- 
tersection has nothing to do with the case. Competition 
with descending supply curves will always lower the price 
so long as there are any competitors with descending supply 
curves. No check to this fall is possible until either com- 
petition ceases or the supply curve ceases to descend. If 
the supply curve at some point at the right reaches a mini- 
mum point, this marks the lowest point to which the price 
can fall ; or if the crowding out of competitors finally leaves 
only one supplier in the field, he at that moment becomes a 
monopoHst, and the prices will cease falling on that ac- 
count. 

Monopoly may also come about in another way, as 
already suggested, i.e. by combination. When there is 
cutthroat competition, the motive to combine is strong. 
None of the competitors relish the prospect of being crowded 
out any more than they relish the prospect of continued 
cutthroat competition. Whether combination will actu- 
ally result or not depends on a variety of circumstances. 
One or more of the competitors may flatter himself that the 
rate war will end in crowding out all others except him, and 
prefer to keep up the fight to the bitter end. Others may 
keep on from other motives, being prevented by pride or 
resentment either from withdrawing from the contest or 
from begging their rivals to form a combination. But for 
our present purpose it does not matter much whether the 
monopoly which finally results comes from the final survival 



INFLUENCES BEHIND SUPPLIES 289 

of one supplier or from deliberate combination. In either 
case the result is monopoly. 

We find, then, as a result of our study of the supply side 
of the market that supply curves sometimes descend, and 
that in such cases competition is " cutthroat " competition, 
and results in losses and tends toward monopoly. 

In all our reasoning we have assumed perfect competition 
to start with. It should be noted that in actual fact com- 
petition is usually somewhat imperfect. The slight under- 
cutting of price by one grocer will not ruin the trade of 
another in another part of the same town for the reason 
that the two are not absolutely in the same market. Each 
has a sphere which the other can only partially reach, partly 
because of distance and partly because each has his own 
" custom," i.e. the patronage of people who, from habit or 
from other reasons, would not change grocers merely 
because of a slight diJfference in price. Thus each is pro- 
tected by his partial isolation. So that even when supply 
curves descend, competition may be so limited as to prevent 
any very fierce rate war, the rate war being prevented by 
partial or local monopolies among the suppliers in the first 
place. A rate war, therefore, is never a permanent or nor- 
mal condition. If not avoided at first by imperfect com- 
petition or by partial monopoly, it is avoided eventually 
by the monopoly to which it leads. 

§ 7. Fixed and Running Costs 

We have now to notice another pecuharity on the supply 
side of the market. The peculiarity referred to is the fact 
that there are often costs wliich do not vary with supply, but 
remain unchanged whether the supply is large or small or 
nothing. These are called the fixed costs as contrasted 
with the costs wliich vary with supply, which are called the 
running costs. If all costs are in the form of actual money 
expenses, the two classes are also called respectively fixed 



290 ELEMENTS OF ECONOMIC SCIENCE 

expenses and running expenses. The fixed expenses of a 
railway company, for instance, consist of the interest on its 
bonds. The running expenses consist of the salaries, wages, 
fuel, materials, etc. The only costs hitherto included in 
our discussions were running costs. The fixed costs were 
not included because they have no effect on supply schedules 
(or curves) . Our only purpose now in stud3dng fixed costs is 
to show that they do not have any effect on supply, a fact 
at first surprising. 

In general, fix:ed costs of production of any given goods 
consist simply of interest on past costs which have been 
^^ sunk " in the business, i.e. which cannot now be reimbursed 
to the owner except as the sale of these said goods may do 
so in part or in whole. As we have seen in a previous chap- 
ter, interest is not a cost to society, for it is merely a payment 
from one person to another. To society as a whole the only 
cost is the '' sunk " cost, which, in the last analysis con- 
sists, as has been explained, of the labor expended at various 
times in the past. But to the individual suppHer. — and 
his is the only cost in which we are at present interested — 
interest is a cost. If he pays no interest, he must have in- 
curred the " sunk " cost himself, in which case this past 
sunk cost replaces the fixed annual cost. In one of the two 
ways he must bear the burden of sunk cost. That is, either 
he must have borne it in the past directly, or he must now 
be paying interest to some one else who so bore it. The 
two wa3^s are equivalent in the same sense that two goods 
are equivalent which exchange for one another. That is, a 
sunk cost of $100,000 is equivalent, if interest is 5 per cent,, 
to a fixed cost of $5000 a year. Whether the individual 
person or company has sunk the $100,000 in the past or is 
paying $5000 a year to some one else who did, — in neither 
case does this cost enter into the cost (or undesirability) 
curve, or the resultant supply curve or the resultant price. 

We shall cite some examples which have been almost 
literally reahzed in actual Hfe. A man once sunk some 



INFLUENCES BEHIND SUPPLIES 29 1 

$100,000 in a hotel on the top of a mountain. He found 
that so few guests wanted to go there that the most he 
could earn was only $2000 beyond his running expenses. 
He never succeeded in recovering the sunk cost, and the 
fact that he had sunk $100,000 gave him no power to com- 
mand prices high enough to enable him to succeed. Nor 
could he withdraw from the business and recover his 
$100,000. His total building was worth nothing except for 
hotel purposes. He could only make the best of his mis- 
investment and run his hotel for the sake of $2000 a 
year. This was better than nothing at all, which would 
have been the result of going out of business. The $100,000 
sunk in the past was sunk just the same, whether the hotel 
was run or not. Another hotel keeper borrowed $100,000 
on bonds and paid interest at 5 per cent, i.e. $5000 a year to 
the bondholders. His business paid running costs, but 
only $2000 beyond those costs, so that he failed by $3000 
to earn enough to pay his' interest to the bondholders. 
The hotel was losing, in actual money expended, $3000 a 
year. But even in this case the hotel could not be aban- 
doned. The only result was to change owners. The bond- 
holders foreclosed their mortgage and ran the hotel them- 
selves. As it still earned $2000 beyond running expenses, 
they found it more profitable to continue the business than 
to close out. 

In either of these two cases, whether the hotel was built 
by the owner out of his own purse or out of borrowed money, 
there was a loss equivalent to three fifths of the original 
cost, or what amounts to the same thing, the interest thereon. 
Yet this cost could not be avoided, whether the hotel busi- 
ness were large or small or abandoned altogether, and it 
" paid " to run at a loss rather than to close down at a 
greater loss. This paradox, that '' it sometimes pays to 
run at a loss," is important to analyze and to understand. 

A third hotel keeper made a lucky hit in his $100,000. 
He got not only his running expenses and interest on the 



292 ELEMENTS OF ECONOMIC SCIENCE 

$100,000, but a handsome profit besides. But this fact did 
not affect the prices at which he was willing to supply 
accommodations. 

The point to be emphasized is that in all three cases the 
fixed costs had no influence on prices. Whether these costs 
are easy to carry, as in the last case, or burdensome, as in 
the other two, they have no influence on prices. In each 
case the owner tries to make the most he can. The fixed 
costs take out the same amount, whatever he does, and may 
therefore be disregarded in deciding what is best to do. 

It follows that fixed costs will not even prevent prices, 
under the stress of competition, from going below what will 
pay those costs. A railway may be making money enough 
to pay both its running and fixed expenses and a handsome 
surplus besides, imtil a parallel road is built. Then each 
tries to take business away from the other; a rate war 
ensues, and prices of freight and passenger services are driven 
down. Each road is now running behind on its interest 
payments, yet neither can afford to stop running, for then it 
would run behind still further. We have here the same cut- 
throat competition as when the supply curve descends, ex- 
cept that in this case it is " cutthroat " because of the fixed 
costs. If also the supply curve descends, then there are 
two conditions tending toward cutthroat competition, i.e. 
the existence of fixed costs and the existence of descending 
supply. As a matter of fact, these two conditions are often 
united. 

§ 8. General and Particular Running Costs 

The two are not only often associated, but are at bottom 
very similar to each other. This may be seen best if we di- 
vide one of our classes of costs, running costs, into two sub- 
classes, '' general " costs and '' particular " costs. By 
general costs, also called " overhead costs," are meant costs 
which, though they could be gotten rid of if the business 
ceased, will not greatly vary vrhether the business is large 



INFLUENCES BEHIND SUPPLIES 293 

or small. They include the labor of superintendence, sal- 
aries of the chief officers, rent of rented quarters, interest 
on short- time loans for stock carried, etc., power, lighting 
and heating, insurance and repairs. By particular costs — 
also called ratable or distributive costs — are meant costs 
which vary almost or quite in proportion to the amount of 
product sold. They include raw materials and cost of ordi- 
nary wages. 

Now when the supply curve descends, i.e. when running 
costs decrease with increase of supply, the reason is usually 
found in the '' general costs." As the total " general costs " 
remain httle changed by an extension of the supply, the 
general costs per unit supphed grows smaller, the larger the 
supply. These costs, added to the particular costs, which re- 
main practically the same, evidently cause the total running 
cost per unit to decKne with an increase in production. 

Now the reason that fixed costs were not treated Kke 
general costs, and included in the computation of the 
average cost per unit, was because, as we have seen, fixed 
costs could make no difference to the price at which the 
suppher is wilHng to supply a given amount, to show 
which is the object of the supply schedule (or curve) . The 
suppher is not willing to sell at prices below what is neces- 
sary to cover general costs, for he has the option to escape 
these general expenses by going out of business entirely. 
But he is willing, if need be, to sell at prices below what is 
necessary to cover fixed costs ; for from these there is no 
way of escape. He might have escaped them once had he 
not made the original investment, but now it is too late. 
The difference between fixed and general expenses, then, is 
chiefly one of dates. When a man is contemplating build- 
ing a hotel, and forecasting his possible profits or losses, he 
will try to make his prices cover fixed costs ; for they are then 
in the future ; but after the hotel is built, he will no longer 
do this. The fixed Costs are then past and beyond recall, and 
he must let bygones be bygones. 



294 ELEMENTS OE ECONOMIC SCIENCE 

Since, then, his cost and supply curves are independent of 
fixed costs, the price which results from this supply curve 
and the demand curve will be independent also. This con- 
clusion is consistent with what has been said in previous 
chapters as to price and value being dependent on the future 
and not on the past. We have seen that, on the demand 
side, people who buy any good buy it on the basis of what 
benefit it will do them in the future ; now we see that, on the 
supply side, those who sell it, sell it on the basis of what it 
will cost them in the future to continue in the business, 
and not on the basis of costs which were sunk in the past. 
The principle has been stated (somewhat imperfectly) as 
follows : — 

" The price of any article is not determined by its cost of 
production, but by its benefits." The imperfection in this 
statement is its failure to discriminate p^st from future. 
The costs of production, if they be future, do enter into 
value, precisely as future benefits enter. Future costs are 
estimated in advance just as future benefits are. For in- 
stance, the value of the Panama Canal to-day is dependent 
upon its future expected benefits, taken in connection with 
the future expected cost of completion. Past elements are 
without significance. The future elements being given, 
the value of the canal will be the same whether the past 
cost was large or small, or nothing at all. Of course it is 
true that the future expected cost for completing the canal 
is less than if some of the work had not been already ac- 
comphshed, so that the greater the past cost has been, the 
less the future cost ought to be, and hence the greater the 
present value of the canal. 

§ 9. Monopoly Price 

The supreme principle which guides economic action is 
the principle of maximum gain. This principle apphes both 
to competition and monopoly, but its apphcation is different 



INFLUENCES BEHIND SUPPLIES 295 

in the two cases. In the case of competition the price set 
by competitors is an important element which must be 
reckoned with, while in the case of monopoly this element 
is lacking. In fact, monopoly is best defined as absence of 
competition. 

In explaining the principle on which monopoly price is 
fixed, we shall first assume that competition is entirely ab- 
sent, there being no fear even that high prices will lead to 
competition in the future. 

Under these circumstances the monopolist will adjust his 
price to what he thinks will be the effect on demand. He 
will charge " all the traffic will bear," i.e. will put up his 
price to the point which will give him a maximum profit 
over cost. The higher the price, the larger the profit per 
unit sold. But the higher the price, the less the demand, 
i.e. the sales he can make at that price. If he makes his 
price too high, he kills the sales. If he makes it too low, he 
kills his profit per unit. By trial and error or by exercise 
of his best judgment, he steers a middle course, and selects 
that price which he thinks will render his profit a maximum. 

In general, the price under monopoly will be higher than 
under competition, but this will not always be the case if, as 
often happens, the costs under monopoly are less than the 
costs under competition. In some cases monopoly results 
in lowering costs so much that the greatest profit is secured 
by setting the price lower than under competition. Such 
economies in cost come from getting rid of duplications in 
plant, management, and advertising, and by giving the ad- 
vantages in general of large-scale production. 

When monopoly price exceeds price under competition, 
there is usually danger that the high price will invite com- 
petition. Practically such danger is seldom absent. Com- 
petition which is feared, but not in actual existence, is called 
potential competition. This potential competition has an 
effect similar to real competition, so that under monopoly 
the price is usually not quite " all the traffic will bear," but 



296 ELEMENTS OF ECONOMIC SCIENCE 

something between that and the price that would result from 
actual competition. In general, prices are seldom deter- 
mined under conditions either of perfect monopoly or of 
perfect competition. There is usually a partial monopoly 
or, what is the same thing, imperfect competition. 

There are many and obvious evils in monopoly. The evils 
of high prices are the least of these. There are the evils of 
crushing competitors by lowering prices and then raising 
them afterward; the evils of discrimination, or charging 
different prices to different persons or locaKties ; and there 
are the dangers of political corruption and control. The 
reader will have an opportunity in other books to study 
these evils and the proposed remedies. He should, however, 
avoid the common but false conclusion that all monopolies 
are evil. In fact, a chief lesson from this chapter is that, 
on the contrary, competition is sometimes an evil, i.e. 
when it is of the cutthroat kind, for which some form of 
monopoly is the only remedy. When any business involves 
a large sunk cost or has a descending cost curve, and there- 
fore a descending supply curve, competition becomes of the 
cutthroat kind. Even if we refrain from sympathy for 
those producers who lose by such competition, we must not 
fail to note that in the end consumers will lose also. The 
reason is that when cutthroat competition is feared, 
producers will avoid sinking capital in such enterprises. 
It is largely in recognition of this fact and in order to en- 
courage such investment that patents and copyrights are 
given. These are monopolies expressly fostered by the 
government. Herbert Spencer once invented an excellent 
invahd chair, and, thinking to give it to the world without 
recompense to himself, did not patent it. The result was 
that no manufacturers dared risk undertaking its manu- 
facture. Each knew that if it succeeded, competitors would 
spring up and rob them of most or all of their profits, while, 
on the other hand, it might fail. Enforced railway com- 
petition has sometimes resulted in killing railway enterprise. 



INFLUENCES BEHIND SUPPLIES 297 

The rise of trusts, pools, and rate agreements is largely due 
to the necessity of protection from competition, precisely 
analogous to the protection given by patents and copyrights. 
Combinations are largely the result of the two conditions 
we have been considering, — the fact that the supply curve 
descends, and the fact that there is large invested capital. 
The anti-trust movement does not take these facts into 
account, nor does it understand the necessities which have 
led to monopoly and that, if we do not allow trade agree- 
ments, trade is practically impossible to-day. 



CHAPTER XVIII 

MUTUALLY RELATED PRICES 

§ I. Prices of Competing Articles on the Demand Side 

We have seen how the price of any particular good is 
determined under varying conditions of competition and 
under monopoly. In each case the particular price has been 
considered, quite apart from other prices. We found that 
each price was determined by its own supply and demand. 
But " supply and demand " were expressed by schedules 
or (curves) which in turn depend upon schedules of desir- 
ability which themselves depend on innumerable outside 
conditions — included among them being the prices of 
other articles besides the particular articles in question. 
In fact, we have seen that these separate curves are affected 
by the general level of prices. We now have to observe 
that they are also particularly affected by other prices. 

It is evident that the price of coal will affect the demand 
for coke, for coal and coke are often substitutes, or com- 
peting articles. Two sorts of wealth are said to be substi- 
tutes when they fill similar needs. It follows that the sat- 
isfaction of these needs by one of the two substitutes not 
only reduces its marginal desirability, but affects the mar- 
ginal desirability of the other in a similar fashion. Conse- 
quently the marginal desirabihties of the two tend to fall 
or rise in unison. Consequently also the prices of the two 
tend to fall or rise together. The more nearly either of 
the two articles comes to filHng the office of the other, the 
more closely do their prices keep pace with each other. If 
two articles are absolutely perfect substitutes, they are to 

298 



MUTUALLY RELATED PRICES 295 

all intents and purposes the same article, and have the 
same price. 

Hitherto we have regarded the schedule (or curve) of 
marginal desirabihty of any article as an ultimate fact or in 
our analysis. But behind it He innumerable determining 
causes, and one of the most important is the prices of sub- 
stitutes available. 

There is scarcely an article which does not have its sub- 
stitutes. The two fuel substitutes, coal and coke, include 
numerous subclasses and varieties, such as anthracite and 
bituminous coal. Other fuel substitutes are wood, petro- 
leum, gasoKne, alcohol, and gas. A change in the price of 
any one of these tends to produce a similar change in the 
prices of the rest. Likewise the prices of food substitutes 
are sympathetic — the prices of such substitutes as wheat, 
corn, oats, rice, and barley ; of fish, meat, and fowl ; of the 
various fruits and the various vegetables ; or of clothing 
substitutes, such as woolen, cotton, linen, and silk; or of 
ornamental substitutes, such as diamonds, pearls, rubies, 
and amethysts. The closest substitutes, though still suffi- 
ciently distinguishable to prevent their being quite classed 
as the sam_e article, are the various "qualities," "grades," or 
" brands " of any particular class of articles. There are 
many grades of wheat, of sugar, of coffee, of meat, of silk, 
and in fact of almost any class of articles which can be 
named. Among different grades the prices are usually so 
closely parallel that trade journals often give the price of 
one staple grade only,' — as of a standard grade of coffee, — 
leaving it to the reader to infer what the prices of the other 
grades must be. But the prices of different qualities of any 
good, though they rise and fall together, may be wide apart 
among themselves. Various quahties of land, for instance, 
bring very different prices, ranging from almost nothing to 
thousands of dollars per square foot. When the various 
" quahties " yield precisely the same sort of benefit, the 
only differences among them are differences in the quan- 



300 ELEMENTS OF ECONOMIC SCIENCE 

titles of benefits which flow from them. In this case the 
prices of the goods will evidently be proportioned to the 
quantities of benefits they yield. Wheat lands, for in- 
stance, of different fertiHty, will be worth prices propor- 
tioned to the quantities of wheat which they yield. 

From what has been said of substitutes, it would evidently 
be a mistake to think that the price of each different article 
can be determined independently, i.e. without reference to 
the prices of other articles. 

§ 2. Prices of Completing Goods on the Demand Side 

Substitutes may be called competing articles. We now 
consider completing articles. Completing articles are ar- 
ticles which jointly serve the same want. We have seen 
that of two competing articles one is used instead of the 
other for a given purpose. But of two completing articles 
one is used in conjunction with the other for a given purpose. 
Horses and mules are competing instruments for the purpose 
of drawing loads. A horse and a cart are completing instru- 
ments for the same purpose. We have seen that the essen- 
tial attribute of competing articles was the tendency of their 
marginal desirabilities to keep pace with each other, and the 
consequent tendency of their prices to correspond. In the 
case of completing articles it is the quantities of the articles 
which tend to maintain a constant ratio. In the case of 
perfect competing articles the ratio of their prices is abso- 
lutely constant. In the case of perfect completing articles 
the ratio of the units used is absolutely constant. Right 
and left shoes, for instance, being, practically speaking, 
perfect completing articles, the numbers of rights and lefts 
keep in a ratio of equahty. One-legged people are too few 
to seriously modify that relation. The prices of two com- 
peting articles tend to move sympathetically, but the prices 
of tv/o completing articles tend to move inversely. If 
horses are abundant and therefore cheap, the tendency is 



MUTUALLY RELATED PRICES 3OI 

to make the competing mules cheap also, but to make the 
completing carts dear ; for the more horses used, the more 
carts will be needed, and the increased demand for them 
will tend to raise the price. 

Articles which are related to each other as completing are 
almost as common as those which relate to each other as 
competing. Various articles of food are used in combina- 
tion, as, for instance, bread and butter, or the elements of 
which a sandwich is composed. A daily diet is usually con- 
structed with regard to the fitting together of the different 
courses served, and of the meals as a whole. Similarly, the 
various parts of one's wardrobe are arranged with reference 
to each other, and again, a dv^elling and its various furnish- 
ings are mutually adapted. The tables and chairs, crock- 
ery, knives, and forks, beds and bedding, rugs and wall- 
paper, are all arranged in relation to each other and to the 
house which they furnish. 

§ 3. Similar Relations on the Supply Side 

Thus far we have considered only goods which compete 
with each other, or complete each other in respect to de- 
mand. Turning now to the supply side of the market, we 
find similar relations. 

Two goods compete in supply when they occasion similar 
efforts or costs to those who sell them. Thus, hay and 
wheat — though far from being substitutes on the demand 
side, for they fulfill dissimilar wants — are to some extent 
substitutes on the supply side, for they require similar costs. 
Both require the use of farm land and the labor of mowing 
or reaping. The prices of such articles competing in supply, 
like those of articles competing in demand, tend to rise or 
fall together. The best example is found in the services of 
laborers. The wages, or the prices paid for various kinds 
of work, tend to keep pace with each other. Man is so ver- 
satile a machine that one kind of v/orkman can readily sub- 



302 ELEMENTS OF ECONOMIC SCIENCE 

stitute for another. On a pinch, the same man may be 
a factory employee, a farm hand, a coachman, carpenter, 
mason, plumber, or clerk. Consequently, these various sorts 
of work, though filhng very unlike wants on the demand 
side, compete on the supply side, and tend to bear similar 
prices. If the wages of clerks rise, the wages of carpenters 
will rise also, because otherwise many carpenters would 
want to become clerks. The consequence is that wages of 
all sorts usually rise or fall together. If labor of all kinds 
could be perfectly substituted, wages of all kinds would 
remain in absolutely fixed ratios to each other, i.e. would 
rise or fall together in exactly the same ratios. Such " per- 
fect mobihty of labor," however, never exists. On the 
contrary, labor may be classified into several more or less 
*' non-competing groups," such as brain work, skilled work, 
and unskilled work. 

Two goods complete each other in supply when jointly 
they involve the same cost, i.e. when the supply of one tends 
to carry with it the supply of the other. The less important 
of the two is then called the by-product of the other. Tal- 
low is a by-product of beef and hides. Other examples 
of articles completing each other in supply are mutton and 
veal ; coal, coke, and gas. 

The prices of two completing goods on the supply side 
tend to move in opposite directions, just as we saw was the 
case on the other side of the market. Consider, for instance, 
beef and hides. If the price of beef rises, the amount sup- 
plied at the higher price will increase. Hence the supply 
of hides will be increased at the same time. Consequently 
its price will fall. 

We see therefore, that two articles may be competing on 
the demand side by replacing each other in satisfying the 
same desires, or on the supply side by requiring the same 
sort of costs ; and also that they may be competing on the 
demand side by jointly satisfying the same desire, or on 
the supply side by jointly requiring the same costs. 



MUTUALLY RELATED PRICES 303 

In all the cases thus far considered, the relationship be- 
tween articles is on the same side of the market. We next 
proceed to consider goods, the relation between which in- 
volves both sides of the market. 

§ 4. Prices of " Tandem " Goods 

The supply of one article may have relationship to the 
demand of another. This is true of two articles, one of 
which is used in producing the other. Such goods may be 
called " tandem " goods because one follows after the 
other. In this respect their relationship differs from the 
others discussed. Substitutes are, as it were, '^ abreast '^ 
of each other, whereas wool and woolen cloth, for instance, 
go tandem. Wool is used (as raw material) in producing 
woolen cloth. Hence the prices of wool and woolen cloth 
are intimately related to each other. The relation, however, 
is different from those relations hitherto considered. Wool 
and woolen cloth are not competing or completing goods on 
either side of the market. Their relation consists in the fact 
that the producers or sellers of woolen cloth are the con- 
sumers or buyers of wool. Both the demand and the sup- 
ply side are involved. They demand wool to supply woolen 
cloth. 

The prices of tandem goods move in sympathy. It is 
evident, for instance, that given a high price for wool, the 
prices in the supply schedule (or curve) for woolen cloth 
will be higher than otherwise, and as a consequence the 
market price of woolen cloth will rise. Conversely, given a 
high price for woolen cloth, the prices in the demand sched- 
ule (or curve) for wool will be higher than otherwise, and as 
a consequence the market price of wool will rise. Thus, any 
change in price of either of these two articles will tend, 
sooner or later, to make the price of the other move in the 
same direction. 

In the same way cotton and cotton cloth are tandem 



304 ELEMENTS OF ECONOMIC SCIENCE 

articles, and their prices are likely to move in sympathy 
with one another ; likewise the prices of wood and houses ; 
of wheat, flour, and bread, or of iron mines, iron ore, pig 
iron, rolled iron, steel, steel rails, and railways. This chain- 
like or serial relationship comprises other elements than raw 
materials and finished products. Thus, steel is related to 
the labor and coal consumed in its manufacture in much the 
same way as it is to the iron ore out of which it is wrought. 
The price of steel therefore moves in sympathy not only 
with the price of iron but with that of the coal and labor 
as well as of all the other goods employed in its production. 
The series or chain of tandem goods is the chain of produc- 
tive processes already discussed. 

§ 5. Efforts and Satisfactions the Ultimate Factors 

This tandem relationship enables us to see clearly the 
fact that, at bottom, supply rests on efforts, and demand on 
satisfactions. We have seen in economic accounting that 
all items of income and outgo cancel among themselves, ex- 
cept efforts and satisfactions. We now see this same truth 
in its application to supply and demand. As simple as this 
truth is, it is commonly overlooked because people are 
blinded by the all-pervading presence of money receipts 
and expenses. The business man, reckoning in money, 
comes to think of money expenses and money receipts as 
though they were real costs and benefits in the productive 
process, whereas they are only the representatives of real 
costs (efforts) and real benefits (satisfactions). We dis- 
entangle ourselves from the meshes of this money snare 
when we see that the controlling factors in determining 
prices are satisfactions on the demand side and efforts on 
the supply side. Between efforts and satisfactions there 
may be innumerable intermediate stages, at each one of 
which supply and demand results in a market price, but 
each such price represents simply anticipated satisfactions 



MUTUALLY RELATED PRICES 305 

or efforts translated into money valuations. Any dealer 
at intermediate stages, between efforts preceding him and 
satisfactions following after, has but little independent 
influence on price. He is like a link in a chain or a cogwheel 
in a machine, merely receiving and transmitting. If some 
real cost of production, earlier in the chain, i.e. some effort 
(or labor) is saved, he receives the cheapening effect from 
those of whom he buys, and passes it on to those to whom 
he sells. If some real benefit is reduced, i.e. some satisfac- 
tion diminished, as by a change of fashion, he receives the 
effect from those to whom he sells, and passes it back to 
those from whom he buys. The supply and demand of 
wheat, in the Chicago wheat pit, for instance, is chiefly de- 
pendent on the labor of wheat growing or the satisfaction of 
bread eating. If a new labor-saving reaping machine is 
devised which reduces the actual effort of producing wheat, 
the effect is soon felt by the Chicago wheat dealer and 
transmitted to his customer. Or if people turn to a rice 
diet and no longer care much for bread eating, this effect is 
also soon felt by the Chicago dealer and passed back to the 
wheat producer. 

An intermediate dealer may not know the ultimate causes 
of the changes in supply and demand which affect his busi- 
ness on either side, and sometimes he does not try to think 
beyond what he immediately observes. He is apt to be 
content to explain simply one of the two prices which in- 
terests him in terms of the other. Wholesale merchants 
often offer to their customers, the retailers, as an explana- 
tion of the rise in their charges, the fact that they have to 
pay higher prices to the jobber ; or again, they may offer to 
the jobber as an explanation of the fact that they cannot 
pay as much as before, that they cannot get as much from 
the retailers. Any such explanation of prices is shallow, 
for it goes no farther than explaining one price by another. 

We see, then, that everything intermediate which hap- 
pens in the economic machinery represents merely steps 



306 ELEMENTS OF ECONOMIC SCIENCE 

in the connection between effort and satisfaction. When 
Robinson Crusoe supplied his wants, there was a direct 
connection between his effort in picking berries, for instance, 
and the satisfaction of eating them. To-day there are a 
number of links between these, but the same principle still 
appHes. Supply and demand at intermediate points is bor- 
rowed from efforts and satisfactions. 



CHAPTER XIX 

INTEREST AND MONEY 

§ I. The Importance of Interest 

We have seen that, in the last analysis, prices depend on 
comparisons between satisfactions or efforts or both. But, 
since these satisfactions and efforts are not all simultaneous, 
but are distributed in time, their comparison requires us to 
take account of interest. Consequently our study of prices 
will not be complete without a study of the rate of interest. 
It is only by means of the rate of interest, expUcitly or im- 
plicitly employed, that the prices of most goods are reck- 
oned. The rate of interest, as previously explained, is it- 
self a sort of price. And it is by far the most important 
sort of price with which economics has to deal. 

Most people have an idea that the rate of interest is a 
technical Wall Street phenomenon, not concerning any one 
but money lenders or borrowers. This is partially true of 
exphcit or contract interest. But there is imphcit interest 
to be considered. An exphcit rate of interest is the rate 
of interest expKcitly stated in a contract. An implicit rate 
of interest is the rate of interest reahzed by an investor who 
makes sacrifices at one time for the sake of compensating 
benefits at a later time. Imphcit interest is also called 
profits. If we invest in a bond, for instance, the price that 
we pay carries with it the imphcation of a rate of interest 
we expect to reahze on the investment. The implicit rate of 
interest, or the rate which we reahze, is that rate of interest 
which, when used for discounting the income of the bond, 
will give the price at which we bought the bond. For in- 
stance, if a bond yielding $4 a year for 10 years, and then 

307 



308 ' ELEMENTS OF ECONOMIC SCIENCE 

redeemable for $ioo, sells now for $105, we know the rate 
of interest realized is not 4 per cent, as it would be if it sold 
at par. It is less than 4 per cent — about 3.6 per cent. 
The implicit rate of interest we realize on such a bond may be 
found, as we have already seen, from a mathematical table. 
When a man buys stocks instead of bonds, or a house or 
a piece of land, the same element of implicit interest enters 
into the transaction. He cannot even buy a piano or an 
overcoat or a hat without discounting the value of the use 
which he expects to get out of it. The rate of interest, then, 
is not confined to Wall Street, but is something that touches 
the daily hfe of us all. 

How, then, is this important magnitude, the rate of inter- 
est, determined ? The problem of interest is one of the most 
perplexing problems with which economic science has had 
to deal, and for two thousand years people have been 
trying to solve the riddle. 

§ 2. A Common Money Fallacy 

Among the earliest explanations of the rate of interest was 
that it is a payment simply for money, and that conse- 
quently it depends upon the quantity of money on the mar- 
ket. In particular, this theory of interest claims that 
plentiful money makes the rate of interest low. We com- 
monly speak of interest as the '^ price of money," and the 
trade journals tell us that " money is easy " in Wall Street, 
meaning that interest is low or that it is easy to borrow 
money. Or we are told that ''the money market is tight," 
meaning that it is hard to borrow money. Probably the 
great majority of unthinking business men beheve that in- 
terest is low when money is plentiful, and high when money 
is scarce. We often hear the argument that the present 
high cost of living cannot be due to any plentifulness of 
money, because, if money were really plentiful, it would 
be cheap, meaning that the rate of interest would be low. 



INTEREST AND MONEY 309 

The fallacy consists in forgetting that plentiful money raises 
the demand for loans just as much as it raises the supply. 
If, for instance, a dealer in pianos wishes to borrow in order 
to stock up his store with pianos, supposing that the price 
of pianos is $200 apiece, and that he wishes to have a 
stock of 50 pianos in his salesroom, he evidently will have 
to borrow $10,000. He goes to the bank and borrows it. 
Now, let us suppose that money becomes more abundant. 
This man will have an idea that in some way he will get a 
lower rate of interest at the bank because, he reasons, the 
bank will have more money in its vaults and will be more 
anxious to lend it out. What he forgets is that the result 
of money being more abundant will be that prices in gen- 
eral will rise, and presumably the price of pianos in particu- 
lar will rise ; therefore, in order to get 50 pianos, he will have 
to borrow twice as much money to enable him to pay for 
his pianos at the doubled prices. In order to buy 50 
pianos, he will need $20,000 instead of $10,000. Likewise 
every other borrowing tradesman will need to have twice 
as much money to conduct the same business. The fact 
that the banker has twice as much money to lend is there- 
fore completely offset by the fact that the borrowers will 
want to borrow twice as much. The consequence is that 
doubKng the amount of money will not affect the rate of 
interest in the least. It will simply affect the amount of 
money lent and borrowed. We must remember that 
interest is not only the price of money, but it is the price in 
money. Interest is unlike any other price in that it is the 
price of money, but it is like all other prices in that it is the 
price in money. Thus the rate of interest is found by 
dividing $5 per year by $100. Both the numerator and 
the denominator of this fraction are expressed in terms of 
money. If we pay attention only to the denominator, we 
are apt to think that an increased supply of money should 
decrease the rate of interest. But if we are to have a one- 
sided view, we might just as well fix our attention only on 



3IO ELEMENTS OF ECONOMIC SCIENCE 

the numerator, and maintain that an increased quantity 
of money ought, instead of decreasing the rate of interest, 
to increase it. The truth is, inflation of money works equally 
on both sides. In mechanics one of the first things we 
learn is that a man cannot raise himself by pulling up on his 
boot straps. The reason is that he is pulling himself down 
as much as up. The inflation of the currency pulls interest 
up on the demand side as hard as it pulls it down on the 
supply side. 

We should beware of the phrase '* the price of money, "for 
it has two meanings. It may mean the rate of interest y 
which is a ratio of exchange between two moneys, the price 
of money capital in terms of money income ; or it may mean 
the purchasing power of money over other goods. The abun- 
dance of money will, as we have seen, reduce its price in the 
sense of purchasing power over goods, but it need not on 
that account reduce its price in the sense of the rate of 
interest. Yet the idea that the plentifulness of money 
tends to make interest low is a persistent one among busi- 
ness men. 

One reason for this idea is that bankers look upon money 
always in relation to their reserves, and if bank reserves are 
low, they have to raise the rate of interest to " protect " 
those reserves. If the reserves are abundant, bankers re- 
duce the rate of interest in order to get rid of the reserve. 
The banker is constantly watching his reserve, and has to 
adjust the rate of interest with respect to this reserve. The 
only way to get rid of a plethora of money in the reserves is 
to lower the rate of interest, and the only way to protect 
a depleted reserve is to raise the rate of interest. But the 
banker is unconsciously measuring the amount of money in 
his bank relatively to the amount of money outside. What 
he forgets is that more reserves in his vaults does not neces- 
sarily mean plentiful money, nor when we have, as at pres- 
ent, for instance, a great quantity of money throughout the 
world, does this fact necessarily imply that Banker Smith 



INTEREST AND MONEY 31I 

will have more gold in his vaults. The money may get into 
the pockets of people first ; it may in that way raise prices 
so high that the borrowers at banks may demand, for the 
reasons explained, larger loans. And yet, if for some reason 
a due share of the money does not at first flow into the banks, 
the results will be that Banker Smith will have too httle 
reserve in relation to the greater loans that are now de- 
manded of him. The consequence, then, will be actually to 
raise the rate of interest. When, therefore, the banker 
says that more money lowers the rate of interest, he ought 
to say, " When bank reserves get an undue fraction of 
money, the rate of interest will be low ; but when an undue 
fraction goes into circulation outside of banks, the rate of 
interest will be high." In other words, an increase of 
money will operate in two different ways, according to 
where it happens to go first. Normally and eventually, as 
we have seen in a previous chapter, an increase of money 
distributes itself between pockets, tills, and bank reserves, 
so as not to disturb the normal ratio between them. If this 
happens, then the rate of interest will not be affected at all, 
which is the normal result. 

This conclusion is not based merely on theory. As a 
matter of statistical fact, the rate of interest does not go 
up when money is scarce and down when money is abun- 
dant. For instance, an examination of the figures for per 
capita circulation of money in the United States for thirty- 
five years shows that in about half of the cases, when money 
grows more abundant, interest is higher, and in half of the 
cases it is lower. In other words, interest moves with ab- 
solutely no relation to the quantity of money in circulation. 

§ 3. Effect during Appreciation or Depreciation 

We conclude, then, that an inflation of the currency does 
not affect the rate of interest, provided^ however, the inflation 
affects the loan at the time a loan is made just as much as ij 



312 ELEMENTS OF ECONOMIC SCIENCE 

affects the repayment at the time the repayment is made. But 
the loan and the repayment do not occur at the same time ; 
there is an interval of time between them, and it may be 
that the degree of inflation is greater or less at the end than 
at the beginning of this period, and in this case the change in 
the inflation may affect the rate of interest during the process 
of change. While it is true, as we have just emphasized, that 
after inflation has taken place no effect is produced on the 
rate of interest, nevertheless, while inflation is taking place 
there is an effect on the rate of interest because the effect of 
inflation on the sum loaned is different from the effect on 
the sum repaid. 

Here, again, we encounter one of those transitional effects 
already referred to when we were discussing money and 
prices. Suppose, for instance, that prices are rising at the 
rate of i per cent per annum. Then, $ioo lent to-day is 
equivalent in purchasing power not to $ioo repayable next 
year, but to $ioi repayable next year. If prices hadn't 
risen, the borrower would have had to pay back as his prin- 
cipal $ioo, and this would have meant the same amount of 
goods as were represented by the $ioo when he borrowed it. 
In terms of goods he would have been in the same position 
at the end as at the beginning, and so would the lender. 
But we are supposing that prices are rising. Then the 
lender, if he gets back as his principal only $ioo, does not 
get back as much purchasing power as he lent, and the bor- 
rower does not pay back as much purchasing power as he 
borrowed. In other words, the fact that prices have risen 
during the year has made it easy for the borrower and made 
it hard for the lender. During the Civil War the United 
States government issued a great many " greenbacks." The 
result was an inflation of the currency and a consequent 
rise of prices, and the result of that was that men who had 
mortgaged their farms in the West were paying back their 
loans, and found it very easy. As they said, the mortgages 
on their farms " disappeared like smoke." If they had 



INTEREST AHD MONEY 313 

borrowed in i860, say $5000, the $5000 they paid back in 
1864 really only represented half as much purchasing power 
over goods, for prices had doubled; the inflation of the 
currency freed them from half their debts. We see, then, 
that when prices are rising, the principal of a debt becomes 
less and less valuable. If prices are rising i per cent, then 
the principal of the debt ought to be increased about i per 
cent in order that there should be exactly the same burden 
on the borrower in paying back as there would have been if 
prices had not risen. In order to compensate for this rise 
of prices, if prices are rising at i per cent per annum, the 
borrower ought to pay an extra dollar on each $100 bor- 
rowed ; so that, if the rate of interest were 5 per cent when 
prices were low, and will be 5 per cent after prices are high, 
it ought to be about 6 per cent while prices are rising i per 
cent per year. In that case, a man who has borrowed $100 
pays back $106, of which $101 is the equivalent of the prin- 
cipal he borrowed. He calls the whole $6 interest, so that 
the rate of interest expressed in money would be 6 per 
cent, in order to be equivalent to 5 per cent when prices 
are stationary. The rise of interest is a sort of compensa- 
tion for the falKng value of the principal; the interest is 
increased in order to offset the depreciation in the principal. 
If prices are rising 2 per cent per annum, we need to add 
2 per cent to the rate of interest, and so on. On the other 
hand, if prices are falling, we must reduce the rate of in- 
terest to offset the appreciation of the principal. If prices 
are faUing i per cent per annum, the equivalent of a 5 per 
cent rate of interest during stationary prices would be about 
4 per cent. 

This ideal compensation in the rate of interest would 
occur if man's foresight were perfect. If we knew abso- 
lutely, for instance, that next year's prices were going to 
be 2 per cent higher than this year, the rate of interest 
would be 2 per cent greater than otherwise. So, also, if we 
knew absolutely that all prices would be i per cent less a 



314 ELEMENTS OF ECONOMIC SCIENCE 

year from to-day than to-day, the rate of interest during the 
year would be, on that account, i per cent less than other- 
wise. But we never know the future exactly ; we can only 
guess. Consequently lenders and borrowers do not make 
perfect compensation. The facts show that the general sen- 
timent is that prices probably will neither rise nor fall. 
People are apparently reluctant to believe that prices are 
going to change very much in either direction. The result 
of this inadequacy of foresight is that, when prices are rising, 
the rate of interest is usually high, but not so high as it 
should be to make a perfect compensation for the rise ; and 
that, on the other hand, when prices are falling, the rate of 
interest is usually low, but not as low as it should be to 
make a perfect compensation for the fall. 

A study of the periods of rising and falHng prices in the 
United States, England, Germany, France, China, Japan, 
and India verifies these principles. It shows that, in gen- 
eral, when prices are rising, the rate of interest is high, and 
when prices are falling, it is low. 

§ 4. Effect of Unequal Foresight 

Another peculiarity of transition periods must be men- 
tioned. This pecuHarity grows out of the fact that differ- 
ent persons differ greatly in their power to foresee. In 
general, borrowers foresee better than lenders. The great 
borrowers of to-day are not the ignorant poor, but the 
alert and well-informed rich. It is the function of these 
people to look ahead, and the consequence is that they 
foresee a rise or fall of prices more quickly than the lender 
or bondholder, who are only silent partners in business. 
Now, a consequence of the superiority in foresight, of bor- 
rowers over lenders, is that the borrowers are willing to 
pay a higher rate than they have to pay, whereas the lenders 
do not see any reason for raising the rate of interest. Sup- 
pose that the rate of interest, on a basis of stationary prices, 



INTEREST AND MONEY 315 

is 5 per cent, and that prices are rising 2 per cent per annum. 
We know that the rate of interest ought to be 7 per cent in 
order to make things even; but let us suppose that the 
borrowers foresee that prices are going to rise 2 per cent per 
annum, and they are perfectly wilhng to pay 7 per cent, where 
otherwise they would pay 5 per cent. But the lenders are 
not alert enough to see why interest should be more than 
5 per cent. The consequence will be that the rate of inter- 
est will not rise as high as 7 per cent but will be some- 
thing hke 6 per cent. The consequence of this in turn is 
that the borrowers, who are wilhng to pay 7 per cent to get 
the same loans that they used to get at 5 per cent, when 
they find that they do not have to pay 7 per cent, but can 
get loans at 6 per cent, will increase the size of their loans. 
Thus borrowers are encouraged to borrow more. Likewise 
lenders are encouraged to lend more, for they find that they 
can get 6 per cent when they are willing to take 5 per cent. 
This 6 per cent is low in the eyes of the borrowers, but high 
in the eyes of the lenders. The consequence, therefore, is 
an inflation of loans stimulated from both sides of the 
market. 

In a previous chapter we saw that an increase of loans of 
banks makes an increase of deposits, inflates the currency, 
and makes prices rise further, and so on around the circle 
of inflation, loans, deposits, and inflation again. The cir- 
cular process has to come to a stop sometime, but it never 
does come to a stop until the rate of interest is adjusted. As 
long as the rate of interest still stays too low, borrowing will 
continue. Presently people wake up to the danger of this 
condition of inflated loans and deposits, the rate of interest 
does go up, discouraging loans and precipitating a crisis. 
Then v\^e have the back-flow : prices decreasing, interest 
falling, and a discouragement of business. This has all 
been explained in a previous chapter. What needs empha- 
sis here is that the essential difficulty in all these changes is 
with the rate of interest. The rate of interest is the key 



3l6 ELEMENTS OF EEONOMIC SCIENCE 

to the situation. Were the rate of interest properly ad- 
justed, there would be less trouble, if, indeed, there would be 
any at all. Crises would be fewer and they would be less 
severe. 

How, then, can we get a better adjustment of the rate of 
interest? One way is to prevent these changes in price 
levels as much as possible. This we have already discussed. 
Another is to have men more alive to the future and more 
quick to predict what is going to happen to prices. Edu- 
cation on this line will go on and is going on through the 
trade journals. Still another way is through the removal 
of the existing prejudice against raising the rate of interest. 
We still inherit the old idea that interest is " usury " or 
robbery. If we could once get rid of the prejudice against 
allowing the rate of interest to rise high as well as to fall 
low, that is, could regard the rate of interest as properly 
subject to fluctuation and as being a market price changing 
day by day, Hke any other price, a long step v/ould be taken 
toward preventing crises. 



CHAPTER XX 

IMPATIENCE FOR INCOME THE BASIS OF INTEREST 

§ I. The Productivity Theory 

In the preceding chapter we have considered the relation 
of money to the rate of interest. We saw that the money 
supply has no effect on the rate of interest except during 
transition periods. The real riddle of interest, therefore, still 
remains unsolved. Why is there such a thing as a rate of 
interest, even when the purchasing power of money is con- 
stant, and what, then, determines that rate? What other 
factors besides inflation or contraction of the currency affect 
the rate of interest? We must now go back of money and 
study the supply and demand of loans. 

In our study of prices we began by considering first the 
part played by money, and then undertook an analysis of 
supply and demand of goods. We are following the same 
order in our study of that peculiar price called the rate of 
interest. We have thus far considered only the part played 
by money, and now are ready to undertake an analysis of 
the supply and demand of loans. We shall find that, con- 
trasted with the supply and demand of goods, which resolves 
itself in the last analysis into a comparison between differ- 
ent marginal desirabihties and undesir abilities, which are 
simultaneous, the supply and demand of loans resolves itself 
in the last analysis into a comparison between different mar- 
ginal desirabilities and undesirabilities, which are not si- 
multaneous, but are distributed at different points in time. 

Before, however, we can fully justify these propositions, 
we shall need to clear the way by removing some of the many 
fallacies and pitfalls which surround the subject. 

317 



3l8 ELEMENTS OF ECONOMIC SCIENCE 

There is, perhaps, no other " nut " so hard to " crack " 
in all economics as this one of the rate of interest. Before 
most persons have grown old enough to consider the 
subject philosophically, they have absorbed, more or less 
unconsciously, a number of untenable and conflicting 
theories. 

Next to the money fallacies which were considered in the 
last chapter, one of the most persistent fallacies is that " in- 
terest is due to the productivity of capital." If a man who 
has never thought on the subject is asked why the rate of 
interest is 5 per cent, he will almost invariably answer, 
" Because 5 per cent is what investments pay." If you 
have $100 and invest it, and it yields you 5 per cent a year, 
the rate of interest is 5 per cent. A $100,000 mill will pro- 
duce a net income of $5000 a year. A $100,000 piece of 
land will produce a net crop worth $5000 a year, and so on 
throughout the whole series of investments. When the rate 
of interest is 5 per cent, nothing at first sight seems more 
obvious than that it is 5 per cent because capital yields 5 
per cent. Since capital is productive, it seems self-evident 
that an investment of $100 in productive land, machinery, 
or any other form of capital, will receive a rate of interest 
proportionate to its productivity. The proposition looks 
attractive, but it is superficial. Why is the land worth 
$100,000? Simply because this is the discounted value of 
the expected $5000 a year. We have seen in previous chap- 
ters that the value of capital is derived from the value of its 
income, not the value of the income from that of the capital. 
But whenever we discount income, we have to assume a rate 
of interest. One hundred thousand dollars is a capitaliza- 
tion calculated on the basis of 5 per cent interest. If we 
capitaKze $5000 at 5 per cent, and get $100,000, we naturally 
find that we are getting 5 per cent on the investment We 
assumed 5 per cent in the first place. We get out exactly 
what we put in ; but if we are not careful, we delude our- 
selves into thinking that we are getting something we didn't 



IMPATIENCE FOR INCOME THE BASIC OF INTEREST 319 

put in, and thus imagine that the productivity of wealth 
explains the rate of interest. 

It is evident that if an orchard of ten acres yields 100 
barrels of apples a year, the physical-productivity, 10 
barrels per acre, does not of itself give any clew to what 
rate of return on its value the orchard yields. 

The orchard produces the apples, but the value of the 
orchard does not produce the value of the apples; on the 
contrary, the value of the apples produces the value of the 
orchard. 

The following diagram shows the typical relation between 
capital and the productivity of capital in the physical sense 
and also in the sense of value return, — which latter is the 
important factor in stud3dng the rate of interest. 





Present Capital 


Future Income 


Quantities 




Benefits 
•< Value of benefits 


Values 


Value of instruments 



This scheme signifies that (i) any instrument, such, for 
instance, as land, railways, factories, dwellings, or food, 
is the means for obtaining benefits of any kind. This first 
step in the sequence pertains to the study of the " tech- 
nique " of production, and involves no rate of interest. 
(2) The benefits are valued in money. This step pertains 
to the study "of prices. (3) From the value of the benefits 
thus obtained is computed the value of the original instru- 
ment hy the process of discounting. This final process in- 
troduces the element of interest. It is clearly with this last 
process that we are concerned in the study of interest. 

The paradox that, when we come to the value of capital, it 
is income which produces capital, and not the reverse, is, 
then, the stumbling block of the productivity theorists. It 
is clear, of course, in any particular investment, that the 
selling value of the stock or bond is dependent on its ex- 
pected income. And yet business men, although constantly 



320 ELEMENTS OF ECONOMIC SCIENCE 

employing this discount process in specific cases, usually 
cherish the illusion that they do so because their capital- 
value in some vague " other use " actually produces interest. 
They fail to observe that the principle of discounting the 
future is universal, and applies to any investment whatso- 
ever, and that in such a discount-process there is neces- 
sarily assumed the very rate of interest we are seeking to 
explain. It is futile to derive the rate of interest from the 
productivity of capital. 

The futihty of this productivity theory may be further 
illustrated by observing the effect of a change of produc- 
tivity. If productivity makes interest, then a change in 
productivity ought to make a change in interest. Yet, if 
an orchard could in some way he made to yield double its 
original crop, though the productivity of that capital in 
the physical sense would be doubled, in the sense of the rate 
of interest its yield would not be necessarily affected at all, 
— certainly not doubled. For the orchard whose yield of 
apples should increase from $1000 worth to $2000 worth 
would itself correspondingly increase in value. For some 
reason or other people would find themselves calling it a 
$40,000 orchard instead of a $20,000 orchard; and the 
ratio of the income to the capital- value would then remain 
as before, namely, 5 per cent. To raise the rate of interest 
by raising the productivity of capital is, therefore, like try- 
ing to raise one's self by one's boot straps. 

Nor can this conclusion be escaped (as has sometimes 
been attempted) by supposing the increasing productivity 
to be universal. It has been asserted, in substance, that 
though an increase in the productivity of one orchard would 
not appreciably affect the total productivity of capital, and 
hence would not appreciably affect the rate of interest, yet 
if the productivity of all the capital of the world could be 
doubled, the rate of interest would be doubled. Now, doub- 
ling the productivity of the world's capital would not be 
entirely without effect upon the rate of interest; but the 



IMPATIENCE FOR INCOME THE BASIS OF INTEREST 32 1 

effect would not be in the simple direct ratio supposed. 
Indeed, an increase of the productivity of capital would 
probably result in a decrease, instead of an increase, of the 
rate of interest. To double the productivity of capital 
might more than double the value of the capital ; at least 
that it would fail to do so has not been shown by the pro- 
ductivity theorists, much less that capital would remain 
unchanged in value. And if it doubled in value, we should 
have the same result as before. 

§ 2. The Socialist's Theory 

So much for the productivity theory. We have next the 
socialist's theory. The socialist has the idea that interest 
is robbery. He says ^' it is all wrong that the capitahst who 
does not lift a finger should get any pay; he is getting 
something for nothing, and that is interest; interest is 
robbery; interest is sucking the blood out of somebody 
else, viz. the workman." According to the sociaKst theory, 
especially as represented by Karl Marx, interest is exploi- 
tation; it is payment which, for some reason never satis- 
factorily explained, is made to the rich who sit by and do 
nothing, while somebody else produces all the tribute that 
has to be poured into their laps. The socialists say that 
labor produces capital and therefore produces the interest 
from capital, and therefore labor should get all the income 
from capital ; and since the laborer does not get it all, it 
must be held back by somebody who is in a position of 
vantage to steal it. This is the key of so-called " scientific 
sociaHsm." There are many motives for sociaHsm, but so 
far as it has an economic theory behind it, this is it. The 
capitalist, these socialists believe, holds a club over the 
workman and virtually says, " If you will come to-day and 
work for me, I will give you half of what you produce ; I 
have got the capital, and you can't get on without me, and 
therefore I am in a posit>on to rob you." 



322 ELEMENTS OF ECONOMIC SCIENCE 

The socialist's position involves two propositions : first, 
that all income and all capital are practically produced by 
labor ; and secondly, that all the income should be paid to 
the laborer. Now the first proposition is much more nearly 
correct than the second. We need not contest it in order to 
see the fundamental error in socialism. Let it be granted 
that practically every instrument of production is produced 
by labor ; let it be granted that the capitalist is always liv- 
ing on the product of past labor ; that a milhonaire who gets 
his income from railroads, ships, and houses, all products 
of labor, is reaping what labor sowed ; that the capitahsts 
of to-day are receiving compound interest on the labor of 
the past. 

It does not follow that injustice has been done to the 
laborer. Let us consider the case of a tree planted with $i 
worth of labor, and 25 years later worth $3. The socialist 
virtually asks, " Why should not the laborer who planted the 
tree receive $3 instead of $1 for his work? " The answer is 
that he may receive it, provided he will wait 25 years for it ! 
As Bohm-Bawerk says : — 

" The perfectly just proposition that the laborer should 
receive the entire value of his product may be understood 
to mean either that the laborer should now receive the en- 
tire present value of his product, or should receive the entire 
future value of his product in the future. But Rodbertus 
and the socialists expound it as if it meant that the laborer 
should now receive the entire future value of his product." 

It would be a mistake to say that there is no exploitation 
of laboring men by capitalists, because we know the con- 
trary to be the fact, but it is absurd to condemn all interest 
on the ground of exploitation. The basis of interest is 
much deeper. It lies in the preference for present over 
future goods. It is because the laboring man can't wait that 
he is willing to take something less than the whole value, 
and it is right that he should do so, because the capitalist 
does not like to wait either, and the capitaHst is really doing 



IMPATIENCE FOR INCOME THE BASIS OF INTEREST 323 

a favor to the laborer when he pays him in advance for 
planting a tree and waits himself 25 years before getting the 
product. 

§ 3. Impatience the Source of Interest 

f The essence of interest is impatience, the desire to obtain 
gratifications earlier than we can get them, the preference for 
present over future goods. This preference comes from a 
fundamental attribute of human nature. As long as people 
like to have things to-day rather than to-morrow, there will 
be a rate of interest. 

Interest is, as it were, impatience crystallized into a market 
rate. The rate of interest is formed out of the various de- 
grees or rates of impatience in the minds of different people. 
The rate of impatience in any individual's mind is his pref- 
erence for an additional dollar, or one dollar's worth of goods, 
available to-day, over an additional dollar, or dollar's worth 
of goods, available a year from to-day. In other words, it 
is the excess of the marginal desirability of to-day's money 
over the marginal desirabihty of next year's money viewed 
from to-day's standpoint. It can be expressed in numbers 
as the premium that a man is willing to pay for this year's 
over next year's money. If, for instance, in order to get $1 
to-day he is willing to pay $1.05 next year, then his rate of 
impatience is 5 per cent. The present $1 is worth to him 
so much that in order to get it he is willing to pay more than 
$1 in the future for it ; it is because of the wilHngness to do 
this that there is such a thing as the rate of interest. A 
man will prefer to have a machine to-day rather than a 
machine in the future ; a house to-day rather than a house 
a year from now ; a piece of land to-day rather than a piece 
of land when he is ten years older ; he would rather have 
some food to-day than wait until next year for it, or a suit 
of clothes or stocks or bonds, or anything else. J 

But what are these present and future ^' goods " which 
are thus contrasted ? At first sight it might seem that the 



324 ELEMENTS OE ECONOMIC SCIENCE 

" goods " compared may be indiscriminately wealth, prop- 
erty, or benefits. It is true that present machines are pre- 
ferred to future machines ; present houses to future houses ; 
land possessed to-day to land available next year ; present 
food or clothing to future food or clothing ; present stocks 
or bonds to future stocks or bonds ; present music to future 
music, and so on. These seem a very heterogeneous com- 
pound by which to explain so homogeneous a thing as interest. 
But a shght examination will show that some of these cases 
of preference are reducible to others. When present capital 
(whether capital-wealth or capital-property) is preferred to 
future capital, this preference is really a preference for the 
income of the first capital as compared with the income of 
the second. The reason we would choose a present fruit tree 
rather than a similar fruit tree available in ten years is that 
the fruit production of the first will occur earh'er than that 
of the second. The reason one prefers im^mediate tenancy 
of a house to the right to occupy it in six months is that the 
uses of the house will begin six months earlier in one case 
than in the other. In short, capital-wealth available early 
is preferred to capital-wealth of like kind available at a 
more remote time, simply because the income of the former 
is available earlier than the income of the latter. For the 
sam^e reason, early capital-property is preferred to late 
capital-property of a similar kind. For property is merely 
a claim to future income ; and the earlier the property is 
acquired, the earlier will the income accrue, the right to 
which constitutes the property in question. 

Thus, all rates of impatience resolve themselves into 
preference for early income over late income. Moreover, 
the preference for present income over future income re- 
solves itself into the preference for present final income over 
future final income. The income from an article of capital 
which consists merely of an " interaction " is desired for 
the sake of the final income to which that interaction paves 
the way. We prefer present bread baking to future bread 



IMPATIENCE FOR INCOME THE BASIS OF INTEREST 325 

baking because the enjoyment of the resulting bread is 
available earher in the one case than in the other, Present 
weaving is preferred to future weaving, because the earlier 
the weaving takes place, the sooner will the cloth be manu- 
factured, and the sooner will the clothing made from it be 
worn by the consumer. 

When, as is usually the case, exchange intervenes between 
the weaving and the use of the clothes, the goal in the process 
is somewhat obscured by the fact that the manufacturer 
regards his preference for present weaving over future 
weaving as due not to the fact that the clothes will be more 
early available to those who will wear them, but to the fact 
that he will be enabled to obtain a quicker income by selling 
the cloth earlier. To him early sales are more advantageous 
than deferred sales, because the earlier the money is re- 
ceived, the earlier can he spend it for his own personal uses, 
— the shelter and the comforts of various kinds constituting 
his real income. It is not he, but his customers, those who 
buy the cloth he manufactures, that base their preference 
for present cloth over future cloth on the earlier availability 
of the clothes which can be made from it. But in both 
cases the mind's eye is fixed on some ultimate enjoyable 
income to which the interaction in question is a mere pre- 
paratory step. We thus see that all preference for present 
over future goods resolves itself, in the last analysis, into 
a preference for early enjoyable income over late enjoyable 
income. Every preference for present over future goods 
reduces itself, therefore, to this preference for present satis- 
factions over future satisfactions. 

The preference for present over future goods, when thus 
reduced to its lowest terms, rids the values of the contrasted 
present and future goods of the interest element, which, in all 
other attempts at explanation, is so unconsciously presup- 
posed. When any other goods than enjoyable income are 
considered, their values already imply a rate of interest. 
When we say that interest is the premium on the value of 



326 ELEMENTS OF* ECONOMIC SCIENCE 

a present house over that of a future house, we are apt to 
forget that the value of each house is itself based on a rate 
of interest. For, as we have seen, the price of a house is the 
discounted value of its future income, and in the process of 
discounting there always lurks a rate of interest. The 
value of houses will rise or fall as the rate of interest falls or 
rises. Hence, when we compare the values of present and 
future houses, both terms of the comparison involve the 
rate of interest. If, therefore, we undertake to make the 
rate of interest depend on the relative preference for present 
over future houses, we are making it depend on two ele- 
ments, in each of which it already enters — present 
houses and future houses. The same is true of all capital, 
and also of those items of income which we have called inter- 
actions ; for the value of an interaction is the discounted 
value of the ultimate income to which that interaction leads. 
We could not rest satisfied in the statement that interest is 
the premium on the value of present tree planting over 
that of future tree planting; for the value of each tree 
planting itself depends on the rate at which the future 
income from the tree is discounted. But when present 
ultimate income is compared with future ultimate income, 
the case is different, for the value of ultimate income in- 
volves no interest whatever. We see, therefore, that the 
reduction of the problem of interest to a comparative value 
of present and future enjoyable income avoids the diffi- 
culty of making interest depend on magnitudes which them- 
selves depend in turn on interest. 



CHAPTER XXI 

INFLUENCES ON IMPATIENCE FOR INCOME 

§ I. Influence which Time-shape of Income exerts on the 
Rate of Impatience 

But we have not yet wholly solved the problem of interest. 
It is not enough to know that the more impatient a people 
are, the higher will their rate of interest be, and that the 
more patient they are, the lower their rate of interest. We 
must also know on what causes the rate of impatience de- 
pends. It depends principally upon the character of one's 
enjoyable income. Smith's rate of preference for present 
over future satisfactions will depend on the abundance of 
his present over his future satisfactions. If the future sat- 
isfactions that he expects and looks forward to are very great, 
and his present satisfactions are very small, he will be im- 
patient to leave his present scarcity and arrive at the 
expected future abundance ; that is, he have a high rate of 
preference for present over future satisfactions. This is on 
the same principle that prices are high when goods are scarce. 
The preference for present satisfactions is high if present 
satisfactions are scarce. Now the rate of preference which 
Smith has for present satisfactions over future satisfactions 
will depend on his whole future stream of satisfactions, that 
is, what we call his final enjoyable income. It will depend 
on four characteristics of that income : first, as just said, 
it will depend on the time-shape of the income, — the rela- 
tive abundance of his present and his future satisfactions; 
second, on the amount of the income, i.e. whether his satisfac- 
tions are few or many ; third, on the composition or make-up 
of the income, i.e. in what proportions it consists of the 

327 



328 



ELEMENTS OF ECONOMIC SCIENCE 



gratifications of the palate, of vanity, clothing, shelter, and 
the other elements which make up income ; and fourth, on 
the uncertainties of the income, i.e. to what extent his sat- 
isfactions throughout future years can be depended upon. 
The rate of impatience of any individual depends, then, 
on the character of his income, i.e. on four characteristics of 

income: — .^ ^. , 

its tmie-shape 

its amount 

its composition 

its uncertainties 

This proposition — that the preference of any indi\ddual 
for present over future income depends upon the nature 

of his prospective 



Fig. 39. 



enjoyable mcome — 
corresponds to the 
proposition in the 
theory of prices, that the marginal desirabihty of any article 
depends upon the quantity of that article; both proposi- 
tions are fundamental 
in their respective 
spheres. 

We have first to 
consider the influence 
upon the rate of im- 
patience, of time- 
shape of income, i.e. 
the distribution of in- 
come in time. Four 
different types of time- 
shape may be dis- 
tinguished : uniform 
income, consisting of ' 
equal yearly items, as 
represented in Figure 39; increasing income, as repre- 
sented in Figure 40; and decreasing income, as repre- 



FlG. 40. 



INFLUENCES ON IMPATIENCE FOR INCOME 



329 



sented in Figure 41. The effect of possessing an 
increasing income (Fig. 40) is, as we have just seen, to make 
the possessor impatient, i.e. to make his preference for 
present over future income higher than otherwise ; for it 
means that the earHer income is relatively scarce, and 
the remoter income, relatively abundant. A man who is 
now enjoying an income of only $1000 a year, but expects 
in ten years to be enjoying one of $10,000 a year, will prize 
a dollar to-day far more than a dollar due ten years hence. 
He has '' great ex- 
pectations." He 
values the present's 
scarce dollars or 
dollars' worth of 
satisfaction more 
highly than the 
future's abundant 
dollars or dollars' 
worth of satisfac- 
tion. He may, to 
satisfy his impa- 
tience, borrow 
money to eke out 
this year's income, — 
and make repay- 
ment by sacrificing from his more abundant income ten 
years later. 

Reversely, a gradually decreasing income (Fig. 41), 
making, as it does, the earlier income relatively abundant, 
and the remoter income relatively scarce, tends to reduce 
impatience, or the preference for present as compared with 
future income. The man with a descending income says, 
^' I have all the money I want to-day, and more perhaps, 
but next year I shan't have as much as I want." He will 
therefore strive to save from his present abundance to pro- 
vide for coming needs. 



Fig. 41. 



330 ELEMENTS OF ECONOMIC SCIENCE 

The extent of these effects will, of course, vary greatly 
with different individuals. Corresponding to a given as- 
cending income, one individual may have a rate of impa- 
tience of lo per cent and another only 4 per cent. What we 
need here to emphasize is merely that, in the case of both of 
these individuals, a descending income causes a lower rate 
of impatience than an ascending income. 

§ 2. Influence of Size and Composition of Income 

So much for the time-shape of a man's income, or its dis- 
tribution in time. Our next topic is the dependence of 
impatience on the size of income. In general, it may 
be said that the smaller the income a man has, the higher is 
his preference for present over future income. It is true 
that a small income impKes a keen appreciation of future 
wants as well as of immediate wants. Poverty bears down 
heavily on all parts of a man's life, both that which is 
immediate and that which is remote. But it enhances the 
utility of immediate income even more than of future income. 

This result is partly rational, because of the importance 
of supplying present needs, in order to keep up the con- 
tinuity of life and the ability to cope with the future ; and 
partly irrational, because the pressure of present needs 
blinds one to the needs of the future. 

As to the rational side, it is clear that present income is 
absolutely indispensable, not only for the present, but even 
as a precondition to the attainment of future income. One 
break in the thread of life is sufficient to destroy all future 
enjoyment. It is of the utmost importance, therefore, to 
keep up life. As the phrase is, "a man must live," and the 
present is the time to keep to life in order to have any life in 
the future. If, then, a man were on a desert island and had 
only such rations as would last a few months, he would 
naturally prefer to use them immediately — sparingly, but 
immediately — rather than to put off their consumption 



INFLUENCES ON IMPATIENCE FOR INCOME 33 1 

ten years, because if he put off consuming them, he couldn't 
consume them at all ; he would die in the meantime. And 
in general, a man who is poor, and upon whom poverty 
presses so as to make it hard to make both ends meet, 
will always have a higher realization and appreciation of 
the future than a man who is rich. 

As to the irrational side, the poorer a man, the more his 
eyes are bhnded to future needs. He is too much occupied 
with the need of the present, and shuts his eyes to the 
future. To him " sufficient unto the day is the evil thereof." 
We all suffer from lack of perspective, and tend to exaggerate 
the needs of the present. But poverty especially tends to 
distort the perspective. Its effect is to relax foresight and 
self-control, and tempt one to " trust to luck " for the fu- 
ture, if only the all-absorbing clamor of present necessities 
may thus be satisfied. 

We see, then, that a low income tends to produce a high 
degree of impatience, partly from lack of foresight and self- 
control, and partly from the thought that provision for the 
present is necessary both for itself and for the future as well. 

We come next to the influence of the composition of the 
income-stream on the rate of impatience of its possessor. 
An income worth $5000 may, for one individual, comprise 
one set of enjoyable services, and for another, an entirely 
different set. The inhabitants of one country may have 
relatively more house shelter and less food element in their 
incomes than those of another. These differences will have 
an influence in one direction or the other upon the rate of 
impatience. Diminution of any one constituent of income 
would have an effect upon rate of impatience similar to the 
effect of diminution of income in general. A decrease of 
the food element would be felt especially, both because this 
element usually forms a considerable part of income and 
because it is 3. prime necessity. 



332 ELEMENTS OF ECONOMIC SCIENCE 

§ 3. Influence of Uncertainties of Income 

The next influence on the rate of impatience and there- 
fore on the rate of interest is risk or uncertainty. Now 
uncertainties affect the impatience in several different ways. 
In general, risks tend to raise the degree of impatience. 
There are four ways in which risk tends to raise, and one in 
which it tends to lower, impatience. 

First, and most famihar, we know that if a loan is risky, 
the rate of interest has to be high. If the repayment of a 
loan is regarded as uncertain, that fact will have to be offset 
by an increase in the rate of interest, and produces a cor- 
responding rate of impatience for risky loans. 

But even the rate of interest in riskless loans will be raised 
by risk in certain ways now to be discussed. The second 
way in which risk tends to raise the rate of impatience 
is in the risk of Hfe. It acts like the risk of a loan. You 
may tell a man he is perfectly sure of being repaid his loan 
fifty years from now. Nevertheless, that will not cause 
him to regard the money which will come fifty years hence 
as equal in value to the money which he has in his pocket 
to-day, because he runs the risk of dying inside of fifty years ; 
it is cold comfort to tell him he is sure to get his money after 
he is dead ! A sailor is a type of man who is constantly 
taking this fact into account. He knows that almost any 
day he may be shipwrecked, and the consequence is he 
prefers money in his pocket to-day to money next year. 
Sailors are proverbial spendthrifts and have a proverbially 
high degree of impatience. 

The third way in which risk tends to increase impatience 
is seen where present income is risky as compared with 
future income. A man in time of war, when there is pros- 
pect of peace in the future, looking forward to a relatively 
safe income in the future, will have a high degree of. im- 
patience for that future to arrive, because the present risky 
income is in his eyes not equivalent to the future safe income. 



INFLUENCES ON IMPATIENCE FOR INCOME 333 

Fourthly, the risk of income may, instead of applying 
especially to remote periods or especially to immediate 
periods, apply to all alike. Such a condition largely explains 
why salaries and wages are lower than the average earnings 
of those who work for themselves. Those who choose salaries 
rather than profits are wilhng to accept a low income in order 
to get rid of a precarious one. Since a risky income, if the 
risk applies evenly to all parts of the income-stream, is nearly 
equivalent to a low income, and since a low income, as we 
have seen, tends to intensify impatience, risk, if uniformly 
distributed in time, must tend to increase impatience. 

These, then, are the four ways in which risk tends to 
increase impatience. There is, however, one way in which 
risk tends to decrease impatience. The instance just given 
is where immediately future income is risky, but income 
thereafter safe. That sometimes happens, as just indicated, 
where in time of war man expects peace in the future, or 
in time of scikness he expects to get well and resume his 
regular earning power. Nevertheless, there are numerous 
examples of the opposite type, where the risk apphes to 
the future and not to the present. If a ship owner, for 
instance, has his ship in port to-day, but is going to sail 
within a few months, his risks are high in the future as 
compared with the present. His future looks dubious, and 
that will cause him to be less impatient, because a risky 
future income is equivalent to a small future income, and 
we have seen that a small future income tends to lessen 
impatience. An income which gets more and more risky 
in the future is therefore like an income which gets more 
and more small in the future. In actual fact such a type 
is not uncommon. The remote future is usually less known 
than the immediate future. This means that the risk con- 
nected with distant income is greater than that connected 
with income near at hand. The chance of disease, accident, 
disability, or death is always to be reckoned with, but 
under ordinary circumstances is greater in the remote 



334 ELEMENTS OF ECONOMIC SCIENCE 

future than in the immediate future. Consequently there 
is usually a tendency, so far as this influence goes, toward 
a low rate of impatience. This tendency is expressed in 
the phrase to " lay up for a rainy day." 

Risk, then, operates in diverse ways according to diverse 
circumstances. We see that risk tends in some cases to 
increase and in others to decrease the rate of impatience. 
There is a common principle, however, in all these cases. 
Whether the result is a high or a low rate of impatience, 
the primary fact is that the risk of losing the income in a 
particular period of time operates as a virtual impoverish- 
ment of the income in that period, and hence increases the 
estimation in which it is held. If that period is a remote 
one, the risk to which it is subject makes for a high appre- 
ciation of remote income; if the period is the immediate 
future, the risk makes for a high appreciation of immediate 
income ; if the risk is in all periods of time, it acts as a 
virtual decrease of income all along the line. 

The rate of impatience depends, then, upon the time- 
shape of an income-stream, its size, its composition, and its 
uncertainties. 

§ 4. Influence of Differences in Human Nature 

It is clear that the rate of impatience which corresponds 
to a specific income-stream will not be the same for every- 
body. One man may have a rate of impatience of 5 per 
cent and another a rate of impatience of 10 per cent, although 
both have the same income. The difference will be due 
to the personal characteristics of the individuals. These 
characteristics are chiefly five in number : (i) foresight, 
(2) self-control, (3) habit, (4) expectation of life, (5) love 
for posterity. We shall take these up in order. 

(i) First, as to foresight. Generally speaking, the 
greater the foresight, the less the rate of impatience, and 
vice versa. In the case of primitive races and uninstructed 



INFLUENCES ON IMPATIENCE EOR INCOME 335 

classes of society, the future is seldom considered in its 
true proportions. The story is told of a Southern negro 
that he would not mend his leaky roof when it was raining, 
for fear of getting more wet, nor when it was not raining, 
because he did not then need shelter. Among such per- 
sons the rate of impatience for present gratification is 
powerful because their comprehension of the future is weak. 
If we compare the Scotch and the Irish, we will find a con- 
trast in this respect. The Irish, in general, lack foresight 
and are improvident, and the Scotch have foresight and are 
provident. Consequently the rate of interest is high in 
Ireland and low in Scotland. 

These differences in degrees of foresight produce cor- 
responding differences in the dependence of impatience 
on the character of income. Thus, for a given income, 
say $1000 a year, the reckless might have a rate of 
impatience of 10 per cent, when the forehanded would 
experience a rate of only 5 per cent. In both cases the 
rate of impatience will depend on the size of the income. 
The lower the income, the higher the rate of impatience 
will be. But the particular rates corresponding to a partic- 
ular income in the two cases will be entirely different. 
Therefore the rate of impatience, in general, will be higher 
in a community consisting of reckless individuals than in 
one consisting of the opposite type. 

(2) We come next to self-control. This trait, though 
distinct from foresight, is usually associated with it and 
has very similar effects. Foresight has to do with thinking, 
self-control with willing. A weak will usually goes with a 
weak intellect, though not necessarily, and not always. 
The effect of a weak will is similar to the effect of inferior 
foresight. Like those workingmen who cannot carry their 
pay home Saturday night, but spend it on the way in a 
grogshop, many persons cannot deny themselves any pres- 
ent indulgence, even when they know definitely what the 
consequences v/ill be in the fuutre. Others, on the con- 



336 ELEMENTS OE ECONOMIC SCIENCE 

trary, have no difficulty in stinting themselves in the face 
of all temptations. 

(3) The third characteristic of human nature which 
needs to be considered is habit. That to which one is ac- 
customed exerts necessarily a powerful influence upon his 
valuations and therefore upon his rate of impatience. This 
influence may be in either direction. A rich man's son who 
has been brought up in habits of self-indulgence, when he 
finds himself with a smaller income than his father pro- 
vided him during his formative years, wiU have a higher 
rate of impatience than a man who has the same income but 
who has cHmbed up instead of climbed down. 

(4) The expectation of Hfe will affect a man's rate of im- 
patience. We have already seen this in another connection. 
A man who looks forward to a long hfe will have a relatively 
high appreciation of the future, which means a relatively 
low appreciation of the present ; whereas a man who has a 
short hfe to look forward to will want it at least to be a 
merry one. " Eat, drink, and be merry, for to-morrow we 
die " is the motto applying to this type. 

If we will take the history of a man's life, we shall find 
that he changes his rate of impatience at successive periods. 
A child will have a high rate of impatience because of his 
lack of foresight and self-control. When he reaches the 
age of young manhood, he may still have a high rate of 
impatience, but for a different reason, viz. because he 
then expects a large future income. He expects to get on 
in the world, and he wiU have a high rate of impatience 
because of the relative abundance of the imagined future as 
compared with the reahzed present. When he gets a httle 
farther along, and has a family, the result will be a low rate 
of impatience, because then the needs of the future rather 
than the endov/ment of the future wifl appeal to him. He 
will not think that he is going to be so very rich in the future ; 
on the contrary, he will wonder how he is going to get along 
in the future because he will have so many mouths to feed. 



INFLUENCES ON IMPATIENCE FOR INCOME 337 

He looks forward to the future expenses of his wife and 
children with the idea of providing for them — an idea 
which makes for a high relative regard for the future and a 
low relative regard for the present. Then when he gets a 
Httle older, and his children are married and gone out into 
the world and are taking care of themselves, he again has a 
high rate of impatience, because he expects to die, and he 
thinks, " Why shouldn't I enjoy myself during the few years 
that remain, instead of piling up for the remote future? " 

So there are four periods in the cycle of a man's life: 
(i) childhood ; (2) young manhood ; (3) the time when he has 
a wife and family to look out for and provide for in the 
future ; (4) and lastly, the time of his Hfewhen he again looks 
out only for himself and expects to die presently. These, 
for different reasons, affect in different ways a man's rate 
of impatience. 

(5) The fifth circumstance is a love for posterity. Prob- 
ably the most powerful cause tending to reduce the rate of 
interest is love for one's children and the desire to provide 
for their good. When these sentiments decay, as they did 
at the time of the decHne and fall of the Roman Empire, and 
it becomes the fashion to exhaust wealth in self-indulgence 
and leave Httle or nothing to offspring, the rate of impa- 
tience and the rate of interest will be high. At such times 
the motto, " After us the deluge," indicates the feverish 
desire to squander in the present, at whatever cost to the 
future. A noted gambler, who had led a wild and selfish Hfe, 
once said, when fife insurance was first explained to him, 
" I have seen many schemes for making money, but this is 
the first time I have seen a scheme where you had to die 
before you could rake in the pile." That man didn't care 
for a payment v/hich would come in after his death. But 
there are many men who do, and in fact care much more for 
it than for anything else in the world. This care leads them 
to insure their fives in order that they may leave the money 
to their famiHes. Their desire to provide for those who 



338 ELEMENTS OF ECONOMIC SCIENCE 

survive them gives them a low rate of impatience. Life 
insurance, by training people to look out for posterity, is 
acting as one of the most powerful means of lowering the 
rate of impatience and therefore the rate of interest. At 
present in the United States the insurance on lives amounts 
to $20,000,000,000. This represents, for the most part, an 
investment of the present generation for the next. The 
investment of this sum springs out of a low rate of impa- 
tience, and tends to produce a low rate of interest. 

Thus we see that men may differ in many ways which 
affect the rate of interest and rate of impatience. We may 
contrast two extreme types of men. Men may have a high 
rate under the following conditions : if (irrespective of the 
character of their income) they are shortsighted, or are 
weak-willed, or have habits of a spendthrift, or look for- 
ward to a short or uncertain Hfe, or are selfish, and have 
no regard for posterity. The opposite characteristics will 
lead to a low rate of impatience : foresight, self-control, 
habits of thrift, length and certainty of Hfe, and altruism 
with respect to posterity. 

Then we see that a man's rate of impatience depends 
(i) upon his income and (2) upon his nature. In the table 
on page 339 we can contrast the extreme types of income 
and the extreme types of human nature, and see how the 
rate of impatience will depend upon the various combina- 
tions involved. 

By comparing the types of income and human nature we 
find nine compartments in the table. If we compare the 
figures in the same vertical column, we see that they grow 
less as we descend, expressing the influence of the character 
of income. If we compare the figures in the same hori- 
zontal line, we see that they grow less toward the right, 
expressing the influence of human nature. But a man may 
have an income-stream of a kind which tends to make a 
high rate of impatience, and at the same time a nature of 
a kind which tends to make a low rate of impatience. The 



LNTLUENCES ON IMPATIENCE FOR INCOME 



339 



result will then be a compromise rate of impatience, say 
5 per cent. Or a man may have an income-stream which 
tends to make his rate of impatience low, and a nature 
which tends to make the rate of impatience high. Thus 
5 per cent is found three times in the table forming a diag- 
onal. The other diagonal shows the contrast between the 
extreme where both the character of the income and of the 
nature of the individual conspire to make a very high rate 
of impatience and the opposite extreme where they conspire 
to make a very low rate of impatience. 



Description of iNcoiCE 


Corresponding Rate op Impatience 
TO AN Individual who is 


Size 


Time-shape 


Composi- 
tion 


Uncertain- 
ties 


Short- 
sighted, 
weak-willed, 
accustomed 
to spend, 
without 
heirs 


Of a mixed 

or medium 

type 


Far-sighted, 

self -con- 
trolled, ac- 
customed to 
save, desir- 
ous to pro- 
vide for 
heirs 


SmaU 


Increas- 
ing 


Food 
scanty 


Precari- 
ous 


20% 


io% 


5% 


Of a mixed or medium type 


10% 


5% 


2% 


Large 


Decreas- 
ing 


Food 
abundant 


Assured 


5% 


2% 


1% 



CHAPTER XXII 

THE DETERMINATION OE THE RATE OE INTEREST 

§ I. Equalizing Marginal Rates of Impatience 

In the last chapter we saw that the rate of preference for 
present over future goods is, in the last analysis, a preference 
for present over future income; that this, preference de- 
pends, for any given individual, upon the character of his 
income-stream, — its size, time-shape, composition, and 
uncertainties, — and that the nature of this dependence 
varies with different individuals. 

The question now arises. Will not the rates of impatience 
of different individuals be very different, and if so, what 
relation do these different rates have to the rate of interest? 
It might seem at first that the rates of impatience would 
differ widely, and that the rate of interest must be some 
sort of average of their different magnitudes. But this is 
incorrect. In a nation of hermits, without any mutual 
lending and borrowing, the rate of impatience of individuals 
would diverge widely, but there would be no rate of interest. 
It is modern society's habit of borrowing and lending that 
tends to bring into equahty the rates of impatience in differ- 
ent minds, and it is only because of the hmitations of the 
loan market that absolute equality is not reached. 

The chief limitation to lending is due to the risk involved, 
and to the difficulty or impossibihty of obtaining the secur- 
ity necessary to eliminate or reduce that risk. Those who 
are most willing to borrow are oftentimes those who are 
least able to give security. It will then happen that these 
persons, shut off from the loan market, experience a higher 
rate of impatience than the rate of interest ruling in that 

340 



THE DETERMINATION OF THE RATE OF INTEREST 34 1 

market» If they can contract loans at all, it will be only 
through the pawnshop or other high-rate agencies. 

But for the moment let us assume a perfect market, in 
which the element of risk is entirely lacking, both with 
respect to the certainty of the expected income-streams 
belonging to the different individuals, and with respect 
to the certainty of repayment for loans. In other words, 
we assume that all individuals are initially possessed of 
foreknown income streams, and are free to exchange any 
part of them so that present income is exchanged for future 
income. We assume, further, that to buy and sell various 
parts of one's income-stream (by loans, etc), is the only 
method of altering that income-stream. Prior to such 
exchange, the income-stream is supposed to be rigid, i.e. 
fixed in size, time-shape, and composition. The capital 
instruments which the individual possesses are each supposed 
to be capable of only a single definite series of services 
contributing to his income-stream. 

Under these hypothetical conditions, the rates of impa- 
tience for different individuals would be perfectly equahzed. 
Borrowing and lending evidently affect the time-shape of 
the incomes of borrower and lender; and since the time- 
shape of their incomes affects their rate of impatience, such 
a modification of time-shape will react upon and modify 
their rate of impatience and bring the market into equi- 
Ubrium. 

For if, for any particular individual, the rate of im- 
patience differs from the market rate, he will, if he can, 
adjust the time-shape of his income-stream so as to har- 
monize his rate of impatience with the interest rate. For 
instance, those who, for a given income-stream have a rate of 
impatience above the market rate, will sell some of their 
surplus future income to obtain (i.e. '' borrow") an addition 
to their present meager income. This will have the effect 
of enhancing the value of the future income and decreasing 
that of the present. The process will continue until the 



342 ELEMENTS OF ECONOMIC SCIENCE 

rate of impatience of this individual is equal to the rate of 
interest. In other words, a person whose impatience rate 
exceeds the current rate of interest will borrow up to the 
point which will make the two rates equal. Reversely, 
those who, with a given income-stream, have a rate of im- 
patience below the m^arket rate, will sell {i.e. " lend ") some 
of their abundant present income to eke out the future, the 
effect being to increase their rate of impatience until it also 
harmonizes with the rate of interest. 

To put the matter in figures, let us suppose the rate of 
interest is 5 per cent, whereas the rate of impatience of a 
particular individual is at first 10 per cent. Then, by hy- 
pothesis, the individual is willing to sacrifice $1.10 of next 
year's income in exchange for $1 of this year's. But in the 
market he is able to obtain $1 for this year by spending only 
$1.05 of next year. This ratio is, to him, a cheap price. 
He therefore borrows, say, $100 for a year, agreeing to 
return $105 ; that is, he contracts a loan at 5 per cent when 
he is wilhng to pay 10 per cent. This operation, by in- 
creasing his present income and decreasing his fiiture, tends 
to reduce his rate of impatience from 10 per cent to, say, 
8 per cent. Under these circumstances he will borrow 
another $100, being now willing to pay 8 per cent, but having 
to pay only 5 per cent. This operation will still further 
reduce his rate of impatience. He will continue to borrow 
until his rate of impatience has been finally brought down 
to 5 per cent. Then for the last or " marginal." $100, his 
rate of impatience will agree with the market rate of inter- 
est. As in the general theory of prices, this marginal rate, 
5 per cent, being once established, applies indifl;erently to 
all his valuations of present and future income. Every 
comparative estimate of present and future which he actu- 
ally makes must be ''on the margin" of his income-stream 
as actually determined. 

In like manner, if another individual, entering the loan 
market from the other side, has at first a rate of impatience 



THE DETERMINATION OF THE RATE OF INTEREST 343 

of 2 per cent, he will become a lender instead of a borrower. 
He will be willing to accept $102 of next year's income for 
$100 of this year's income, but in the market he is able, in- 
stead of the $102, to get $105. As he can lend at 5 per cent 
when he would gladly do so at 2 per cent, he jumps at the 
chance and invests, not one $100 only, but another and 
another. But his present income, being reduced by the 
process, is now more highly esteemed than before, and his 
future income, being increased, is less highly esteemed. 
The result will be a higher relative valuation of the present, 
which, under the influence of successive additions to the 
sums lent, will rise gradually to the level of the market rate 
of interest. 

In such an ideal loan market, therefore, where every in- 
dividual could freely borrow or lend, the rates of impatience 
for present over future income for all the different individuals 
would become equal to each other and to the rate of interest. 

To illustrate these principles by diagrams, let us suppose 
a man has a given income-stream, as indicated in Figure 42. 
It is assumed that his income- 
stream is an ascending one, as \^ 
between this year and next Bon-owed- °' 
year, that is, that this year's | 
income is relatively small and P^^ 
next year's income relatively 

large. It may be that this year he is ill, and therefore has 
not earned his usual amount of money, and that next year 
he expects to get an unusual income from some particular 
source. This man will then probably be impatient to get the 
large income he anticipates. He does not wish to wait till 
next year if he can avoid it. His impatience is due to a 
scarcity of income this year and an abundance of income 
next year. He will wish to adjust his income or rectify the 
disparity by increasing this year's income at the expense 
of next year's income. 

He will borrow, but borrowing changes the time-shape of 



344 ELEMENTS OF ECONOMIC SCIENCE 

his income-stream. His original income in the first year is 
indicated by the height a, and that next year by the 
(greater) height h. The effect of borrowing will be to 
elevate the first line to a' and to depress the second to h'. 
These two adjustments will lessen both the scarcity of this 
year's income and the abundance of next. This will there- 
fore modify the time-shape of his income and lessen the valu- 
ation he puts on a dollar this year as compared with next. 
This reduces the premium he puts on this year's doUar, i.e. 
his rate of impatience. By increasing his loan he can evi- 
dently reduce this premium to conform to the rate of in- 
terest. He can also make other loan contracts or plan to 
make them later, by which he can increase or decrease any 
year's income at the expense of an opposite change in some 
other year or years. In this way he can alter the time-shape 
of his income-stream at will, and he will always so alter it 
as to make his rate of impatience equal to the rate of inter- 
est. He began with a rate of impatience greater than the 
market rate of interest, but ended in harmony with that rate. 
Figure 43 represents the income-stream of a man sup- 
posed to have a rate of impatience at first less than the rate 
a of interest. If we choose, we may 

^b suppose that he has just received 

I I I a smaU legacy which makes this 



Lent- 



to 



year's available income imusuaUy 
^^^' '^^' large, while he expects next year 

to have an unusually small income. Looking forward to 
next year, he sees that it will be hard to get along comfort- 
ably, while this year he has more than he needs. He there- 
fore invests some of his present abundance to the extent of 
aa^ in order to eke out his future scarcity by hh\ He will 
do so, however, only provided his rate of impatience for 
present over future goods is less than the market rate of 
interest, 5 per cent, and he will do so only up to the point 
which will bring down his rate of impatience to the level of 
this rate of interest. 



THE DETERMINATION OF THE RATE OF INTEREST 345 

The two men started out with rates of impatience differ- 
ent from the market rate of interest. The market rate was 
5 per cent, while the first man had a rate of impatience 
above this, and the second a rate of impatience below this. 
But when they finished their loan operations or readjust- 
ments in the time-shape of their income-streams, they 
brought their rates of impatience each into harmony with 
the rate of interest and therefore with each other. There- 
fore, as long as there is a market in which everybody can 
borrow or lend at will at 5 per cent, everybody will have at 
the margin a rate of impatience of 5 per cent. Nobody 
will have a rate of impatience above 5 per cent, because, if 
it is at first above it, he will borrow enough to bring it down 
to the market rate ; and nobody will have a rate below it, 
because if it is at first below it, he will lend enough to bring 
it up to the rate of interest. 

Even men of widely different natures as to foresight, self- 
control, etc., will have the same marginal rates of impatience. 
We have seen that different men, even with precisely the 
same incomes, may have different rates of impatience. But 
in that case they will not continue to have the same sorts 
of income. 

§ 2. Spending and Investing 

It must not be imagined that the classes of borrowers and 
lenders correspond respectively with the classes of poor and 
rich. Personal and natural idiosyncrasies, early training, 
and acquired habits, accustomed style of living, the usages 
of the country, and other circumstances will, by influencing 
foresight, self-control, regard for posterity, etc., determine 
whether a man's rate of impatience is high or low, and 
whether he becomes a borrower or a lender. 

It should be noted that borrowing and lending are not 
the only ways in which one's income-stream may be modi- 
fied. The same result may be accomplished simply by buy- 
ing and seUing property; for, since property rights are 



346 ELEMENTS OE ECONOMIC SCIENCE 

merely rights to particular income-streams, their exchange 
substitutes one such stream for another of equal value but 
differing in time-shape, composition, or certainty. This 
method of modifying one's income-stream, which we shall 
call the method of sale, really includes the former method 
of loan ; for a loan contract is at bottom a sale ; that is, it 
is the exchange of the right to present or immediately en- 
suing income for the right to more remote or future income. 
A borrower is a seller of a note of which the lender is the 
buyer. A bondholder is regarded indifferently as a lender 
and as a buyer of property. 

The concept of a loan may therefore now be dispensed 
with by being merged in that of sale. By selHng some prop- 
erty rights and buying others it is possible to transform 
one's income-stream at will, whether in time-shape, com- 
position, or probability. Thus, if a man buys an orchard, 
he is providing himself with future income in the use of 
apples. If, instead, he buys apples, he is providing himself 
with similar but more immediate income. If he buys se- 
curities, he is providing himself with future money, con- 
vertible when received into true or enjoyable income. If his 
security is a share in a mine, his income-stream is less last- 
ing, though it may be larger, than if the security is stock 
in a railway. 

Purchasing the right to remote enjoyable income is called 
investing; to immediate enjoyable income is called spending. 
The antithesis between " spending " and '' investing " is 
merely the antithesis between immediate and remote in- 
come. The adjustment between the two determines the 
time-shape of one's income-stream. Spending increases 
immediate income but robs the future, whereas investing 
provides for the future to the detriment of the present. 

From what has been said it is clear that by buying and 
selling property an individual may change the conformation 
of his income-stream precisely as though he were specifically 
lending or borrowing. Thus, if a man's original income- 



THE DETERMINATION OE THE RATE OF INTEREST 347 



stream is $1000 this year and $1500 next year, and if, selling 
this income-stream, he buys with the proceeds another 
yielding $1100 this year and $1395 next year, he has not, 
nominally, borrowed $ico and repaid 1 105, but he has done 
what amounts to the same thing — increased his income- 
stream of this year by $100 and decreased that of next year 
by $105, the $100 being the modification produced in his 
income for the first year by selling his original income- 
stream and substituting the final one, and $105 being the 
reverse modification in next year's income. 

We may divide society into the spenders and the savers 
or investors. Figures 44 and 45 show the contrast between 
them. A spender is a person who chooses to enjoy a 



Saver 
a 



xb 
tb 



a 



Spender 

?b 



Fig. 44. 



A B 

Fig. 45- 



larger income in the present than in the future ; a saver 
is a person who chooses to enjoy a smaller income in the 
present than in the future. We suppose that the incomes 
of the two are at first just the same, but the first man 
reacts to his present income-stream differently from the 
second man. He is a natural saver, thinks much of his 
future needs, and will, we shall suppose, have a rate of 
impatience below the rate of interest. He will therefore 
take away from his present income a certain amount in 
order to add to his future income, and will, as shown in 
Figure 44, adjust his income-stream so as to bring the 
present income-stream down from a to a^ and his future in- 
come up from h to h^ . The second man is a natural spender, 
and although he has the same income to start with, he wants 
more immediate income and is willing to sacrifice next year's 



348 ELEMENTS OF ECONOMIC SCIENCE 

income to get it. This means that his rate of impatience 
is above the market rate of interest, and therefore he is a 
borrower and a spender. He will, then, as shown in Figure 
45, add to his present income from a to a', and reduce his 
future income from h to h\ 

§ 3. Futility of prohibiting Interest 

We may now note that interest taking cannot be pre- 
vented by prohibiting loan contracts. To forbid the par- 
ticular form of sale, called a loan contract, would leave 
possible other forms of sale, and, as has been shown, the 
valuation of every property right involves interest. If the 
prohibition should leave individuals free to deal in bonds, 
it is clear that virtually they should be still borrowing and 
lending, but under the name of ^' sale " ; and if " bonds " 
were tabooed, they could merely change the name to " pre- 
ferred stock." It can scarcely be supposed that any pro- 
hibition of interest taking would extend to the prohibition 
of all buying and selling; but as long as buying and 
selling of any kind were permitted, the virtual effect of 
lending and borrowing would be retained. The possessor 
of a forest of young trees, not being able to mortgage their 
future return, and being in need of an income-stream of a less 
deferred type than that receivable from the forest itself, 
would simply sell his forest and with the proceeds buy, 
say, a farm with a uniform flow of income, or a mine with a 
decreasing one. On the other hand, the possessor of a capi- 
tal which is depreciating, that is, which represents an 
income-stream great now but steadily declining, and who 
is anxious to " save " instead of '' spend," would sell his 
depreciating wealth and invest the proceeds in such instru- 
ments as the forest already mentioned. 

It was in such a way, as, for instance, by "rent-purchase," 
that the medieval prohibitions of usury were rendered nu- 
gatory. Practically, at the worst, the effect of restrictive 



THE DETERMINATION OF THE RATE OF INTEREST 349 

laws is simply to hamper and make difficult the finer ad- 
justments of the income-stream, compelling would-be bor- 
rowers to sell wealth yielding distant returns instead of 
mortgaging it, and would-be lenders to buy the same, 
instead of lending to the present owners. It is conceivable 
that " explicit " interest might disappear under such re- 
strictions, but ^' implicit " interest would remain. The 
young forest sold for $10,000 would bear this price, as now, 
because it would be the discounted value of the estimated 
future income ; and the price of the farm bought for $10,000 
would be determined in like manner. The rate of discount 
in the two cases must be the same, because, by buying and 
selKng, the various parties in the community would adjust 
their rates of impatience to a common level — an implicit 
rate of interest thus lurking in every contract, though 
never specifically appearing therein. Interest is too omni- 
present a phenomenon to be eradicated by attacking any 
particular form ; nor would any one undertake it who per- 
ceived the substance as well as the form. In substance, the 
rate of interest represents the terms on which the earlier and 
later elements of income-streams are exchangeable. Inter- 
est can never disappear until present and future dollars 
will exchange at par. This would imply that human 
beings were no longer impatient but considered it no hard- 
ship to wait indefinitely. 

We have supposed each person's income to be '' rigid,'' 
except as it is modified by borrowing and lending, or buying 
and selling. It will, however, make little difference if each 
income, instead of being rigid, is more or less flexible to 
start with. Often the same article may be used in more 
than one way. In such a case the owner merely chooses 
the way which gives the capital the highest value. 
t Since any time-shape may be transformed into any other, 
he need not be deterred from selecting an income because 
of its time-shape, but may choose it exclusively on the basis 
of maximum present value. 



350 ELEMENTS OF ECONOMIC SCIENCE 

§ 4. Clearing the Loan Market 

We have seen that from the standpoint of the individual, 
when a rate of interest is given, he will adjust his rate of 
impatience to correspond with that rate of interest. 

For him the rate of interest is a relatively fixed fact, 
since his own rate of impatience and resulting action can 
affect it only infinitesimally. All he can do is to adjust his 
rate of impatience to it. For society as a whole, however, 
these rates of impatience determine the rate of interest. 
This corresponds to what was said as to the determination 
of prices. We have seen that each individual regards the 
market price, say, of coal as fixed, and adjusts his marginal 
desirabihty or undesirabihty to it ; whereas, for the entire 
group forming the market, we know that these marginal 
desirabilities and undesirabilities fix the price of coal. In 
the same way, while for the individual the rate of interest 
determines the rate of impatience, for society the rates of 
impatience of the individuals determine the rate of interest. 
The rate of interest is simply the rate of impatience, upon 
which the whole community may concur in order that 
the market of loans may be exactly cleared. Supply and 
demand will work this out. 

To put the matter in figures : if the rate of interest is set 
very high, say 20 per cent, there will be relatively few bor- 
rowers and many would-be lenders, so that the total extent 
to which would-be lenders are willing to reduce their income- 
streams for the present year for the sake of a much larger 
future income will be, say, $100,000,000; whereas, those 
who are willing to add to their present income at the high 
price of 20 per cent interest will borrow only, say, $1,000,000. 
Under such conditions the demand for loans is far short of 
the supply, and the rate of interest will therefore go down. 
At an interest rate of 10 per cent, the present year's income 
offered as loans might be $'50,000,000, and the amount 
which would be taken at that rate only $ 20,000,000. There 



THE DETERMINATION OE THE RATE OE INTEREST 351 

is still an excess of supply over demand, and interest must 
needs fall further. At 5 per cent we may suppose the 
market cleared, borrowers and lenders being willing to take 
or give respectively $ 30,000,000. In like manner it can be 
shown that the rate would not fall below this, as in that 
case it would result in an excess of demand over supply, 
and cause the rate to rise again. 

Thus the rate of interest is the common market rate of 
impatience for income, as determined by the supply and 
demand of present and future income. Those who, having 
a high rate of impatience, strive to acquire more present 
income at the cost of future income, and tend to raise the 
rate of interest. These are the borrowers, the spenders, the 
sellers of property yielding remote income, such as bonds 
and stocks. On the other hand, those who — having a low 
rate of impatience — strive to acquire more future income 
at the cost of present income, tend to lower the rate of 
interest. These are the lenders, the savers, the investors. } 

The mechanism just described will not only result in a 
rate which will clear the market for loans connecting the 
present with next year, but, applied to exchanges between 
the present and the remoter future, it will make similar 
adjustments. While some individuals may wish to ex- 
change this year's income for next year's, others wish to 
exchange this year's income for that of the year after next, 
or for a portion of several years' future incomes. The 
rates of interest for these various periods are so adjusted 
as to clear the market for all the periods of time for which 
contracts are made. That is, supply and demand must be 
equal, so as to clear the market for every period of time. 

§ 5. Historical Illustrations 

We have now completed our study of the causes deter- 
mining the rate of interest. If they are correct, we should 
find that the rate of interest is low (i) if in general the people 



352 ELEMENTS OF ECONOMIC SCIENCE 

are by nature thrifty, farsighted, self-controlled, love their 
children, or (2) if they have large or descending income- 
streams ; and that it is high (i) if the people are shiftless, 
shortsighted, impulsive, selfish, or (2) if they have small 
or ascending income-streams. 

History shows that facts accord with these conclusions. 
The communities and nationahties which are most noted 
for the qualities mentioned — ■ foresight, self-control, and 
regard for posterity — are probably Holland, Scotland, 
England, France. Among these people interest has been 
low. Moreover, they have been money lenders, they have 
the habit of thrift or accumulation, and their instruments 
of wealth are in general of the substantial variety. 

On the other hand, among communities and peoples 
noted for lack of foresight and for negligence with respect 
to the future are China, India, Java, the negro communities 
in the Southern states, the peasant communities of Russia, 
and the North and South American Indians, both before 
and after they had been pushed to the wall by the white 
man. In all of these communities we find that interest is 
high, that there is a tendency to run into debt and to dis- 
sipate rather than accumulate capital, and that their dwell- 
ings and other instruments are of a very flimsy and perish- 
able character, built for immediate, not remote, gratifications. 

These examples illustrate the effect on the rate of interest 
of differences in human nature. We now turn to illustra- 
tions of differences in the time-shape of incomes. The most 
striking examples of increasing income-streams are found in 
new countries. It may be said that the United States has 
almost always belonged to this category. 

In America we see exemplified on a very large scale the 
truth of the theory that a rising income-stream raises, and a 
falling income-stream depresses, the rate of interest, or that 
these conformations of the income-stream work out their 
effects in other equivalent forms. A similar causation may 
be seen in particular localities in the United States, espe- 



THE DETERMINATION OF THE RATE OF INTEREST 353 

daily where changes have been rapid, as in mining commu- 
nities. In CaHfornia, in the two decades between 1850 and 
1870, follomng the discovery of gold, the income-stream of 
that state was increasing at a prodigious rate. During 
this period the rates of interest were abnormally high. The 
current rates in the '' early days " were quoted at ij to 2 
per cent a month. '' The thrifty Michael Reese is said to 
have half repented of a generous gift to the University of 
California, with the exclamation, ' Ah, but I lose the 
interest,' a very natural regret when interest was 24 per 
cent per annum." After railway connection in 1869, East- 
ern loans began to flow in. The decade 1 870-1 880 was one 
of transition during which the phenomenon of high interest 
was gradually replaced by the phenomenon of borrowing 
from outside. The residents of California were thus able 
to change the time-shape of their income-streams. The 
rate of interest consequently dropped from 11 per cent to 6 
per cent. 

The same phenomena of enormous interest rates were also 
exemplified in Colorado and the Klondike. There were 
many instances in both these places during the transition 
period from poverty to affluence, when loans were con- 
tracted at over 50 per cent per annum, and the borrowers 
regarded themselves as lucky to get rates so " low." 

§ 6. Interest and Prices 

We have seen that the rate of interest is not a mere tech- 
nical phenomenon, restricted to Wall Street and other 
" money markets," but that it permeates all economic re- 
lations. It is the link which binds man to the future and 
by which he makes all his far-reaching decisions. It enters 
into the price of securities, land, and capital goods gener- 
ally, as well as into rent, wages, and the value of all " inter- 
actions." 

The rate of interest plays a central role in the theory of 



354 ELEMENTS OF ECONOMIC SCIENCE 

prices. It applies to the determination of the price of wealth, 
property, and benefits. As was shown in previous chapters, 
the price of any article of wealth or property is equal to the 
discounted value of its expected future benefits. If the 
value of these benefits remains the same, a rise or fall in the 
rate of interest will consequently cause a fall or rise respec- 
tively in the value of all instruments of wealth. The ex- 
tent of this fall or rise will be the greater, the farther into the 
future the benefits of wealth extend. 

As to the influence of the rate of interest on the price of 
benefits, we first observe that benefits may be interactions or 
satisfactions. The value of interactions is derived from the 
succeeding future benefits to which they lead. For instance, 
the value to a farmer of the benefits of his land in affording 
pasture for sheep will depend upon the discoimted value of 
the benefits of the flock in producing wool. In like manner, 
the value of the wool output to the woolen manufacturer is 
in turn influenced by the discounted value of the output of 
woolen cloth to which it contributes. In the next stage, the 
value of the production of woolen cloth will depend upon 
the discounted value of the income from the production of 
woolen clothing. Finally, the value of the last named will 
depend upon the expected income which the clothing wiU 
bring to those who wear it — in other words, upon the use 
of the clothes. 

Thus the final benefits, consisting of the use of the clothes, 
will have an influence on the value of all the anterior bene- 
fits of tailoring, manufacturing cloth, producing wool, and 
pasturing sheep, while each of these anterior benefits, when 
discounted, will give the value of the respective capital which 
yields them; namely, the clothes, cloth, wool, sheep, and 
pasture. We find, therefore, that not only all articles of 
wealth, but also all the " interactions " which they render, 
are dependent upon final enjoyable uses, and are Hnked to 
these final uses by the rate of interest. If the rate of interest 
rises or falls, this chain will shrink or expand. The chain 



THE DETERMINATION OF THE RATE OF INTEREST 355 

hangs, so to speak, by its final link of enjoyable benefits, 
and its shrinkage or expansion will therefore be most felt 
by the links most distant from these final benefits. For 
instance, a change in the rate of interest will affect but 
sHghtly the price of making clothing, but it will affect 
considerably the price of pasturing sheep. 

A study, therefore, of the theory of prices involves (i) a 
study of the laws which determine the final benefits on 
which the prices of anterior interactions depend; (2) a 
study of the prices of these anterior interactions, as de- 
pendent, through the rate of interest, on the final benefits ; 
(3) a study of the price of capital instruments and capital 
property as dependent, through the rate of interest, upon 
the prices of their benefits. The first study, which seeks 
merely to determine the laws regulating the price of final 
benefits, is relatively independent of the rate of interest. 
The second and third, which seek to show the dependence on 
final benefits of the anterior benefits and of the capitals which 
bear them, involve and depend upon the rate of interest. 

In the theory of prices we found that the ultimate ele- 
ments supplied and demanded were satisfactions and efforts. 

There is involved in each price another special price, viz. 
the rate of interest. Without the rate of interest we may 
only compare simultaneous satisfactions or efforts. With it 
we may compare all that exist. By means of the rate of 
interest any future satisfaction or effort is discounted, and 
thus translated into terms of present value. It enables us 
to pause at every step and appraise the interactions and 
capital which anticipate future satisfactions. In other words, 
by it we capitalize income and form our capital accounts. 

Interest, then, is the universal time-price, finking im- 
pending and remote satisfactions or efforts or both. It is 
literally the previously missing link necessary for a complete 
comparison of efforts and satisfactions at all points of time. 

The study of the rate of interest, therefore, rounds out 
and completes our study of prices. 



356 ELEMENTS OF ECONOMIC SCIENCE 



§ 7. Classification of Price Influences 

We may now fitly review the theory of prices by enumerat- 
ing the various possible causes which might decrease the 
price of, let us say, pig iron. The price of pig iron may fall 
for any one or more of the following reasons : — 

(i) A rise in the marginal desirability of money due either to 

(a) A rise in the purchasing power of money through 

I. A decrease in money or deposit currency, or 
II. A decrease in their velocities, or 
III. An increase in the volume of trade, or to 

(b) An impoverishment or reduction of incomes. 

(2) A fall in the marginal desirability of pig iron due either to 
(a) An increased amount of pig iron through 
I. A decrease in its cost by 

1. A saving of waste. 

2. A saving of labor. 

3. A decrease in the price of iron ore or other 

prices entering into its cost. 

4. An increase in the price of by-products. 
II. A trade war. 

(6) A fall in the marginal desirabihty of a given amount of pig 
iron, through 
I. A decrease in the price of iron products through a 
decrease in the marginal desirability of the sat- 
isfactions they yield because of, 

1. An increase in their amount. 

2. A change in fashion, etc. 
II. An increase in substitutes. 

III. A decrease in completing articles. 

IV. An increase in the rate of interest through an in- 

crease in the marginal rates of impatience. 

1. From a change in incomes. 

(i) By steepening their time-shape. 

(2) By reducing their size. 

(3) By increasing their uncertainties. 

2, From a change in human nature. 

(i) By decreasing foresight. 
(2) By decreasing self-control. 

(3) By increasing shiftless habits. 

(4) By decreasing regard for posterity. 



THE DETERMINATION OE THE RATE OF INTEREST 357 

Back of these causes lie other causes, multiplying endlessly 
as we proceed backward. 

But if we trace back all of these causes to their utmost 
limits, they will all resolve themselves into changes in the 
marginal desirabihty or undesirabiHty of satisfactions and 
of efforts at different points of time and of the marginal rate 
of impatience as between any one year and the next. 



CHAPTER XXIII 



RENT 



§ I. Distribution according to Agents of Production and 
according to Owners 

We began this book with a study of economic accounting. 
In this way we obtained a bird's-eye view of the whole field 
of economic science. At that time we had to take ready- 
made the m.aterials for constructing our accounts. This 
material consisted of the values of various items, whether 
of capital or of income. These values consist in each case 
of two factors, the quantity of the goods valued and its 
price. We have now finished the study of one of these two 
factors, price, and there remains for us only the study of 
the other quantity. We have explained how the price of 
instruments, property rights, and benefits, which enter into 
capital and income accounts, is determined. We have still 
to explain how the quantities of instruments, property 
rights, and benefits are determined. What determines, 
for instance, the quantity of wheat which a given wheat 
field will produce; what determines the quantity of the 
wheat fields ; what determines the quantities of the neces- 
sities, comforts, luxuries, and amusements of life which a 
nation or an individual possesses ; what determines the 
quantities of human beings on a given area ? Once we can 
explain these quantities, we need only multiply by the 
prices previously explained, and we have completed our 
task of explaining values. We shall then be able to ex- 
plain — at least in general terms — why, for instance, the 
values of the capital or income in the capital accounts of 
some communities or individuals are so great and of others 

358 



RENT 359 

SO little ; why the value of the benefits flowing from one 
piece of land is so great, and of another so small, and so 
forth. 

Our purpose is not so much absolute, as relative, results. 
We care less about the absolute population of the globe 
than about population relatively to land. We care less 
about the world's total yield of wood than about the yield 
per capita of human beings, per acre of woodland, per loom, 
or per other unit of capital. 

Our present search, then, is for relative quantities, or 
values. There are two sets of relative quantities, or values, 
which are of special importance in our study. One is the 
value of income per unit of physical capital which yields it, 
and the other is the quantity and value of income and of 
capital per human being who owns it. The first represents 
the distribution of income relatively to the agents which 
produce it. The second represents the distribution of in- 
come and of capital among their owners. The study of the 
first will occupy our attention in this and the following 
chapter. 

§ 2. The Four Ratios of Income to Capital 

Our present task, therefore, is to study the ratios of 
income to capital. As we learned at the beginning, both 
capital and income may be measured either in quantity or in 
value. The ratio of income to the capital which produces 
it takes four different forms, according as the income 
and the capital are measured in one or the other of these 
two ways. These four forms of the income- to-capital ratio 
are as follows : — 

(i) There is the ratio of the quantity income, i.e. of the 
benefits per unit of time to the quantity of capital which 
yields those benefits. This may be called the physical- 
productivity of capital. Thus, if lo acres of land, in a 
certain year, yield 60 bushels of wheat, the ratio of income 



360 ELEMENTS OF ECONOMIC SCIENCE 

to capital, or the physical-productivity of this land, is 6 
bushels per acre per year. Or if 10 looms will weave 500 
yards of cloth in a day, the ratio of benefits to the quantity 
of capital, or the physical-productivity of the looms, is 50 
yards per machine per day. 

(2) There is the ratio of the value of the benefits to the 
quantity of the capital. This may be called the value-pro- 
ductivity of capital. Thus, if 10 acres of land yield a net 
return worth $200 a year, the value-productivity is $20 
per acre per year. This is also called the " rent " of land. 
The same principles apply to the rent of any other article of 
capital. Another example of value-productivity is found 
in the wages of a laborer. 

(3) There is also the ratio of the quantity of benefits to 
the value of the capital from which they flow. This may 
be called its physical return. Thus, if $100 worth of capital 
applied to land in the form, say, of agricultural implements 
adds I bushel to the yield of the land, the physical return of 
this accessory capital is xwo of a bushel per year per dollar 
invested. 

(4) There is finally the ratio of the value of benefits to 
the value of the capital yielding them. This may be called 
the value return. Thus, if a house worth $10,000 yields in 
any given year a net rent of $1000, the value return is 10 
per cent per year. 

Thus we have four ratios : — 

1. Quantity of benefits per unit of time ■> - ^ j ..- -4. 
^^^ = physical-productivity. 

quantity of capital 

2. Value of benefits per unit of time , •!-••- 
= value-productivity. 

quantity of capital 

3. Quantity of benefits per unit of time ^ ^^^^^.^^^ ^^^^ 

value of capital 

4. Value of benefits per unit of time ^ ^^^^^ ^^^^^^^ 

value of capital 



RENT 361 

These four magnitudes must be carefully distinguished. 
They are measured in totally different units, e.g. 

The first, in bushels per acre per year. 
The second, in dollars per acre per year. 
The third, in bushels per dollar per year. 
The fourth, in dollars per dollar per year. 

Of these four ratios, the fourth has already been studied 
under the subject of the rate of interest. The third is of 
little importance. There are left, therefore, only the first 
and second. The first is chiefly a technical matter. The 
fertihty of land, e.g. the number of bushels of wheat, oats, 
or corn per acre in Dakota, the efficiency of machinery, 
e.g. the number of yards which a given loom will weave 
or the number of cars a given locomotive will carry, the 
efficiency of workmen, or the number of yards of trench 
they can dig or the number of bricks they can lay. These 
are technical facts the study of which would lead us into 
the particular details of various sorts of business. In a 
sense, these particular studies are included within the 
domain of economic science under the special heads of Ag- 
ricultural Economics, Railway Economics, or Industrial 
Efficiency; but in a book like the present, devoted to a 
mere general outline of economic science, we cannot enter 
into these details. Suffice it merely to say, therefore, that 
physical productivity depends on two chief factors : the 
natural capacities of men, land, and materials ; and the 
acquired knowledge, skill, and organization (including divi- 
sion of labor) by which these natural capacities are utihzed. 
Discoveries of new natural resources and every invention 
of industrial processes add from time to time to physical- 
productivity. The science of agriculture, for instance, has 
been revolutionized in the last few years with the result of 
greatly increasing the physical-productivity of land ; and the 
inventions for applying mechanical power have multipHed, 
by large factors, the physical-productivity of machinery. 



362 ELEMENTS OF ECONOMIC SCIENCE 

§ 3. Value-productivity in General 

Given, then, these technical conditions of natural re- 
sources and acquired methods of utilizing them, let us pass 
at once to what now concerns us, the second of the four 
ratios, the value-productivity of capital, or the ratio of the 
value of the benefits flowing from any capital to the quan- 
tity of that capital. The value of the benefits is found by 
multiplying their quantity by their price. If we consider 
the quantity given by technical conditions and the price 
given by the principles already explained, we have only to 
multiply the two together in order to obtain the value de- 
sired, and then we have to divide this value by the quantity 
of the capital producing it — hkewise supposed for the 
present to be given — in order to obtain the value-pro- 
ductivity desired. Thus, if in any community there are 
1000 lodging rooms, the benefits of which have a price of $1 
per night's lodging, and the total quantity of such benefits in 
a year is 300,000 night's lodging, then the value-productivity 

. , - $1 X ^00,000 . 
IS evidently or ^300 per year per room. In 

order to prepare these productivity data for practical apph- 
cations, we must reduce them to classification. We shall 
fifrst classify value-productivities according to whether the 
prices they bring are explicitly or imphcitly given, explicitly 
by actual sale, or implicitly by mere appraisal. The ex- 
pHcit value productivity of an instrument is called, in 
economic parlance, hire. Hire may be either rent or wages 
according as the hired instrument is or is not a human 
being. The implicit value-productivity of an instrument 
is called profits. Each of these catagories of prices — ex- 
pHcit and impHcit — may in turn be subdivided accord- 
ing to the kind of instruments to which they attach — 
whether, for instance, the instruments are human beings or 
not. The result of these two classifications is the following 
four classes of value-productivity : — 



RENT 363 

The value-productivity of a human being, if explicit, is 
called " expHcit wages " or simply " wages." 

The value-productivity of a human being, if impHcit, is 
called '^ impHcit wages " or " profits produced by men " or 
" enterprisers' profits." 

The value-productivity of any other instrument, if ex- 
phcit, is called '' exphcit rent " or simply ^' rent." 

The value-productivity of any other instrument, if im- 
pHcit, is called " impHcit rent " or " profits of things " or 
" dividends." 

ExpHcit rent and expHcit wages are stipulated and cer- 
tain. ImpHcit rent and impHcit wages are (as is impHed by 
their collective term, profits) subject to chance variations. 
The man who accepts stated payments for the use of his 
instruments for his own services avoids certain risks which 
the independent producer (or profit seeker) assumes. At 
the same time this former foregoes certain chances of gain 
which fall to the latter. 

Thus, profits are " impHcit " wages or rent, and impHcit 
wages or rent are '' commuted " profits. 

§ 4. The Rent of Land 

The remainder of this chapter will be devoted to a study 
of the four kinds of productivities just enumerated. We 
shaU begin with rent — expHcit and implicit. A " rented " 
house bears expHcit rent, but even a house lived in by the 
owner has an implicit rent, i.e. whatever it would rent for 
under assumed conditions. The most common kinds of 
instruments which are explicitly rented are real estate, 
although many other more or less durable commodities 
such as furniture, horses and carriages, telephones, pianos, 
typewriters, and even clothing, may sometimes be ex- 
pHcitly rented. 

Although a piece of real estate is usually rented as a whole, 
including both land and improvements thereon, sometimes 



364 ELEMENTS OF ECONOMIC SCIENCE 

the land and the improvements are rented separately. 
The rent of land separated is called ground rent. Even 
when ground rent is not separated in contract, it may, for 
purposes of discussion, be separated in thought; so that 
all land bears ground rent, either explicit or implicit. Ground 
rent has been the subject of a vast amount of discussion. 
It underlies, for instance, the proposal called " the single 
tax," i.e. that all taxes be laid on ground rent. 

There are two important peculiarities of land which are 
shared by very few other instruments. One of these pe- 
cuHarities is that, practically speaking, the land in the 
world is fixed in quantity. Except by filling in tidal lands, 
and in a few other instances, we cannot add to the world's 
acreage; nor can we subtract from it. It is true that in 
some cases we may materially change the productivity or 
quality of it by irrigation, fertilizing, etc., on the one hand, 
or by exhaustion of the soil and other abuses on the other. 
These alterations in land are more important than has some- 
times been recognized, and their importance is increasing. 
For the present, however, we shall assume a community 
in which the land is fixed, both in quality and quantity, 
possessing, as Ricardo expresses it, '' natural and inde- 
structible powers of the soil." For our purpose it is enough 
to assume that the land is indestructible. That it be natural 
is a matter of indifference ; precisely the same principles of 
valuation apply to land wrested by our ancestors from the 
wilderness as to land solely a gift of nature. 

The second peculiarity of land is that, though fixed in 
quantity, it varies in quality. Land is not a uniform or 
homogeneous article, like pig iron or granulated sugar, 
but consists of innumerable different grades suitable for 
almost innumerable different purposes. The prices of land 
have, therefore, a very wide range, and for ,the most 
part follow the principles of substitutes or competing 
articles. 

It is true that the various lands are not all substitutes. 



RENT 



365 



A city building site is not a substitute for wheat land, nor 
is it either a substitute for forest or mineral lands. But here, 
again, for the sake of simplicity, we shall assume that all 
lands do compete for precisely the same purpose, and differ 
only in productivity. Let us say that the product is wheat, 
and assume : — 




Fig. 46. 



1 . That the land under consideration is fixed in quantity. 

2. That it varies in quality {i.e. productivity) by con- 
tinuous gradation from very fertile to very infertile lands, 
each fixed and invariable as to productivity. 

3. That the cost of tilling each acre is likewise fixed and 
invariable, say $10. 

Let us suppose, as represented in Figure 46, an island 
fulfilling the two conditions above mentioned. In order 



366 ELEMENTS OF ECONOMIC SCIENCE 

further to simplify the picture, let us suppose the most 
fertile land situated in the center capable of producing 25 
bushels of wheat per acre per year, and the other lands 
arranged around it spiral fashion in the order of descending 
productivity. If the population can all be supported on 
the 25-bushel-per-acre land so that no other land is needed 
or beheved to be needed in the future, no lands except this, 
the most fertile, will be used, and none will have value or 
yield rent. The reason is that the supply of land of the 
first quality, which may be had free, exceeds the amount 
demanded. We have seen that under such extreme con- 
ditions of supply and demand the price is low. No one will 
pay for the use of land when, without traveling farther than 
across a field, there is plenty of equally good land to be had 
for nothing. The wheat, however, will have a price equal, 
as previously explained, to its marginal desirabihty meas- 
ured in money, and also to its marginal cost measured in 
money. But we have already assumed that this cost is fixed 
for each grade of land and the same for every bushel. Con- 
sequently the price of wheat is in this case simply equal to the 
marginal cost of producing the wheat. For, if sellers should 
try to sell above this cost, buyers would prefer to grow the 
wheat at that cost themselves. Hence the value of the 25 
bushels produced on an acre of the first-grade land is only 
just equal to the cost of producing wheat there, which, as 
$10 per acre produces 25 bushels, is \^ or 40 cents a bushel. 
But if the population so changes as to create a demand 
for wheat which cannot be supplied from the most fertile 
land, some of the next grade of land will be used, 3delding 
24 bushels per acre. What was before true of only the first- 
grade land will then be true of this second-grade land. It 
will be valueless, and will yield no rent. But no longer will 
this be true of the first-grade land. It will have a value and 
3deld a rent. For there will be a rise in the price of wheat. 
The price will still be equal to the marginal cost, hut now 
the marginal cost is the cost of producing a hushel on the 



RENT 367 

second-grade land. The value of the 24 bushels produced 
on this land will now be equal to the cost of producing 24 
bushels on that land, i.e. $10. This is 14, or about 42 cents 
a bushel. 

But since there cannot be two prices for the same 
article in the same market, the price of the wheat produced 
on the first-grade land [must be the same. Consequently 
the owners of the first-grade land now have a crop worth 
more than the cost of producing it, and can now, if 
they choose, obtain a rent for it equal to the excess, i.e. 
I bushel per acre; for a tenant paying the equivalent of 

1 bushel per acre would have 24 bushels for himself, which 
is exactly the same as he would get if he took up a claim 
for himself on the second-grade land ; and if the landlord 
should attempt to charge more, he would lose his tenant, 
as the latter would then be better off on the second-grade 
land. If he charged less, he would be besieged by appK- 
cations, and would put up his price. The market would 
be cleared by a rent • of i bushel per acre. In money this 
is 42 cents per acre. If the owner does not rent his land 
to another, but enjoys the product himself, he is still said 
to obtain 42 cents an acre of implicit rent. 

If the population changes again so as to require a resort to 
the third-grade land, the price will be still higher, viz. ^^ or 
43I cents per bushel; and the rent of the first-grade land 
will rise to equal the difference between its productivity 
and that of the third-grade land, viz. 2 bushels per acre or 

2 X ,432 cents = 87 cents per acre. Likewise the second- 
grade land will now bear a rent equal to its superiority over 
the third grade, viz. i bushel per acre or 43J cents. In 
the same way we may reckon the rent under other states of 
land occupation. In each case the rent of any grade of 
land is the difference between its productivity and the pro- 
ductivity of the worst or marginal land occupied. If, for 
instance, the lowest grade of land occupied is that indicated 
in the table as having a productivity of 9 bushels per acre, 



368 ELEMENTS OF ECONOMIC SCIENCE 

the rent of the first grade is now 25 — 9 or 16 bushels per 
acre; that of the second grade, 24 — 9 or 15 bushels per 
acre ; that of the next, 23 — 9 or 14 bushels per acre ; and so 
on down to the worst land, which bears no rent. Since the 
price of wheat is, in all cases, its cost of production on the 
worst, or no-rent land, it will now be $10 for 9 bushels or 
$1.11 per bushel. Therefore in money the rents of the 
various lands from the best to the worst will be — 

16 X $1.11 or $17.76 per acre. 
15 X $1.11 or $16.65 per acre. 
14 X $1.11 or $15.54 per acre. 
Etc. 

The last, worst, or no-rent land, is sometimes also called 
the " Ricardian acre " in honor of Ricardo, who first stated 
this doctrine of land rent. Its scientific designation is 
" marginal acre," i.e. it is the last acre whose cultivation 
can be made to pay. This marginal land in a sense fixes the 
rent of all other land and fixes the price of wheat. We have 
reached, then, two important results true under the condi- 
tions supposed. 

1. The price of wheat is equal to its cost of production on 
the margin of cultivation. 

2. Ground rent of any land is the difference between its 
productivity and that of land on the margin of cultiva- 
tion (i.e. the worst cultivated). 

With an increase of population, then, the price of wheat 
and the rent of wheat-land will rise, and the owner of good 
land will become gradually wealthier merely through the 
increase in population. He receives an increment in rent, 
sometimes called " the unearned increment," because it is 
due to no labor on his part. The value of land — that is, 
the capitaHzed or discounted rent — will increase with the un- 
earned increment. It should be noted, however, that during 
the transition of rents from low to high, those who foresee a 
rise in rent will discount in advance the larger future rents. 
Not all so-caUed " unearned increments " are unexpected. 



RENT 369 

These conclusions hold absolutely under the conditions 
assumed. But in the actual world these exact conditions 
are never found. 

1. Land is not absolutely fixed in quantity. 

2. The productivity of any piece of land is not fixed, but 
varies from time to time both in kind and in intensity, and 
this productivity will vary with the price of wheat. 

3. The cost of tiUing land is not fixed, but varies with 
different land, and, indeed, as we shall presently show, is 
influenced by the price of the product. 

The first consideration is of Uttle practical importance. 
The second and third, however, require consideration. The 
productivity of land is not solely a matter of natural fertihty. 
This might be the case with some mineral springs or oil 
wells, but in most cases each piece of land may be more or 
less intensively cultivated ; and a rise in the price of wheat 
will stimulate wheat production on all lands, the better 
grades included. Thus, if the first grade produced 25 
bushels when no other land was in use, it would produce 
more than 25 bushels as soon as the next grade was in use ; 
and the worse the worst grade was, and the higher the price 
of wheat, the greater would be the amount grown by those 
cultivating the superior grades of land. In other words, a 
change in the price of land would not only affect the amount 
of land under cultivation, but the amount of cultivation 
of each piece of land. The productivity of each acre is not 
a constant quantity, but dependent on the price. Each 
acre will be cultivated up to that degree of intensity at 
which the last dollar's worth of cost will barely repay itself. 
That is, not only is there a margin of cultivation as to acres, 
— i.e., the last acre which it pays to cultivate, — but there 
is also a margin of cultivation for every acre, good or bad, 
i.e. the last degree of effort or cost which it pays to put forth. 
Each acre will be tilled until this marginal cost of tilling 
agrees with the market price. 

Moreover, the land may be capable of other uses than 

2B 



370 ELEMENTS OF ECONOMIC SCIENCE 

wheat growing, and a change in the price of wheat may shift 
the use to which certain lands are put. No theory of land 
rent is complete which assumes that the differences in qual- 
ity among lands is merely a matter of the amount of one 
product, like wheat. 

Finally, as to the cost of tilling land per acre, this is not 
a constant quantity for all lands, both good and bad ; nor 
is it constant even for the same land. The cost of tilHng 
may be either higher or lower on good land than on bad 
land ; and, as impHed above, the cost on any land will vary 
with the price just as the product varies with the price, 
although in the opposite direction. The higher the price, 
the greater the marginal cost. This is the law of increasing 
cost apphed to agriculture. It is also often called " the law 
of diminishing returns " ; for to say that the cost of produc- 
ing wheat continually increases with the amount produced 
is evidently the same thing as to say that the amount of 
wheat returned on each dollar of cost continually diminishes. 

While, therefore, the theory of rent as above given is 
correct under the ideal conditions assumed, it is not abso- 
lutely correct under the actual conditions we find in the 
world. In an absolutely correct theory the numbers in 
Figure 46 must be conceived as increasing slightly as the 
margin of cultivation is extended, and the numbers express- 
ing cost will not be simply a constant $10 per each acre, 
but will also increase slightly as the margin is extended. 
But these and the other modifications necessary to make 
the theory of ground rent true to fife are so sHght as not 
materially to change the practical results. 

§ 5. Rent and Interest 

The principles of ground rent apply also to house rent, 
piano rent, or any other rent, except that much greater 
modifications from such illustrative figures as we gave for 
ground rent will be necessary in these cases. In particular, 



RENT 371 

houses, pianos, etc., are not essentially fixed in quantity, 
but their quantity will be changed according to their rent 
(and their price, which is the discounted value of their rent) . 

The practical difference between ground rent and other 
rent, such as house rent, has an important illustration in 
taxation. It is not within the scope of this book to consider 
problems of taxation. We can only remark that a tax on 
ground rent falls on the landlord and does not appreciably 
affect the tenant, because it cannot affect the supply of 
land, which is practically fixed by nature; whereas a tax 
on house rent is borne partly by the tenant, because it dis- 
courages house building and affects the supply of houses. 

The difference, then, between the rent of land and the 
rent of other instruments is a difference in the character of 
the supply. The supply of land is relatively fixed. Other 
instruments are reproducible. It is important to under- 
stand this difference and also not to confuse it with a common 
fallacy that land rent alone is truly rent, and house rent 
and other rent is really interest. It is easy to see that land 
rent is interest on the capital- value of the land just as truly 
as house rent is interest on the capital- value of the house. 
Both are rent and both are interest. In fact, rent and 
interest are simply two different ways of measuring the same 
income value. Rent is value-productivity; interest is 
value-return. We know that the value of income from any 
source may be expressed either relatively to quantity or to 
the value of that source. Rent is expressed in the first way ; 
interest, in the second. 

Let us suppose a quantity of land — 10 acres — to have a 
value of $1000, and that $50 a year is paid for its use. This 
$50 is both rent and interest. It is the rent on the 10 
acres and the interest on the $1000. The rate of rent is $50 
per year for 10 acres or $5 per acre per annum. The rate 
of interest is $50 per year for $1000 or 5 per cent per annum. 
In precisely the same way, let us suppose a quantity of 
houses — 10 houses — to have a value of $100,000, and that 



372 ELEMENTS OF ECONOMIC SCIENCE 

$5000 a year is paid for their use. This $5000 is both rent 
and interest. It is the rent on 10 houses and the interest 
on $100,000. The rate of rent is $5000 per year for 10 
houses or $500 per house per annum, and the rate of in- 
terest is $5000 per year for $100,000 or 5 per cent per annum. 
The erroneous behef that land bears only rent, and other 
instruments bear only interest, is largely responsible for the 
narrow definitions of capital so often given and which are 
so framed as specifically to exclude land. A true analysis 
justifies the usage of business men who apply the term " rent'^ 
as freely to houses as to land, and the term '' interest " as 
freely to income from land as to income from houses. 



CHAPTER XXIV 

WAGES 

§ I. Similarity of Rent and Wages 

Turning from the hire of things to the hire of persons, we 
find a similar but somewhat different problem. The rate 
of hire of human beings is called wages. In case these 
wages are very high, and are paid at rather long intervals, 
they are dignified by the name of salaries. But as the dis- 
tinction between wages and salaries is not based on any 
scientific relation, we shall, for convenience, employ simply 
the one term ^^ wages " to embrace what are ordinarily called 
salaries. 

Corresponding to the distinction between explicit and 
implicit rent, we may distinguish between explicit and im- 
plicit wages, expKcit wages being actual v/ages paid to the 
hired person, called the employee, by the person hiring him, 
called the employer; and implicit wages being the value- 
productivity or earnings of a person who does not sell his 
services but enjoys them himself. We may recapitulate the 
various sorts of hire, explicit and implicit, as follows : — 

Exphcit rent is payment for the use of instruments (other 
than human beings) which are hired. 

Imphcit rent is the value of net income from instruments 
(other than human beings) which are not hired. 

Explicit wages are the payment for the services of human 
beings who are hired. 

Imphcit wages are the net income earned by human 
beings who are not hired. 

The principles governing the rate of wages are, in a gen- 
■ 373 



374 ELEMENTS OF ECONOMIC SCIENCE 

eral way, similar to those governing the rate of rent. The 
rate of a man's wages per unit of time is the product of the 
price per piece of the work he turns out multipUed by his 
productivity. His productivity depends on technical con- 
ditions, including especially his size, strength, skill, and 
cleverness, while the price per piece of his services depends 
upon the general principles of supply and demand as already 
stated. 

The productivity of any capital, whether himian or ex- 
ternal, will differ with the capital, and there will be differ- 
ences in productivity or quality. Men differ in quahty, 
that is, in productive power, as truly as lands or other in- 
struments differ. Some men have a high degree of earning 
power and some have not. Some m.en can work twice as 
fast as others. Some men can do higher grades of work 
than others. The result is that we find men classified as 
common manual laborers, skilled manual laborers, common 
mental workers, superintending workers, and enterprisers, 
or men who take important initiative in conducting indus- 
trial operations. Just as we can measure the rent of any land 
by the difference in productivity between that and the low- 
rent, or no-rent, land, in exactly the same way we can 
measure the difference in productivity between men. 
There is no grade of workmen called the " no-wages men," 
but there would be such a grade if it were customary for 
their employer to pay for their cost or support (as the 
employer of land pays for its^ cost), so that only the 
excess above this cost were to be called wages. There 
are men so incompetent that their net earning power 
is practically zero, and they can barely, if at all, earn 
enough to support themselves. These incompetents may 
be unfortunates, as in the case of invahds and imbeciles, 
or guilty of laziness, as in the case of indolents. But what- 
ever the cause may be, they correspond in economic analysis 
to no-rent land. » 



WAGES 



375 



§ 2. Peculiarities of Labor Supply 

But owing to the fundamental fact that a laborer, unlike 
any other instrument, is owned by himself and not, except 
in slavery, by another, there are certain peculiarities of 
wages as compared with rent. These peculiarities lie in 
the supply curve. We shall note four such peculiarities. 

In the first place, the supply curve of human services 
ascends very rapidly and often even " curls back," as pre- 
viously explained. This pe- 
culiarity, as we saw, was due 
to the fact that a man's 
desire for more money (mar- 
ginal desirabihty of money) 
decreases rapidly with an in- 
crease of his earnings. Be- 
yond a certain point the more 
he is paid, the less he will 
work. We may state the 
same fact in the reverse di- 
rection, and say that under 
certain circumstances\he less ^'^' ^"^ 

a man is paid, the harder he will work. The shape of his 
supply curve will depend in very large measure on whether 
or not he has other sources of income besides his work. 
Figure 47 exhibits this fact. 

The curve S S^ 5'' represents the supply curve of work 
for a rich man who has income from other sources than his 
work, and the curve s / s'^ that for a poor man, who has 
to depend on what he can earn. The rich man will not work 
at all for any wages below a certain price, represented in 
the diagram by OS. Any price above this will induce him 
to work a little, but if the price exceeds the height of S\ 
the result will be that he will work less rather than more. 
These relations correspond with observed facts. A mil- 
Honaire will not work for a dollar a day. He may work a 



Y 






x 








f 


\ 






y 


P 


\ 


I 




/ 




__^ 


f^' 




-r" 








"0 








X 



376 ELEMENTS OF ECONOMIC SCIENCE 

few days in the year for $ioo a day, and work more days 
for $500 a day, but $1000 a day may lead him to work 
fewer days, and devote more time to vacations and to 
enjojdng his large income. 

The poor man will be guided by similar considerations, 
but on a smaller scale vertically and a larger one horizon- 
tally, — if the measure of work in each case is in hours of 
work. Having little or no property besides his person, he 
cannot afford to be idle. Unemployment for him is seldom 
voluntary. So long as he can get a price for his work suffi- 
cient to keep him out of the poorhouse, he will work for 
that price. Thus, the minimum price Os, which is neces- 
sary to induce him to work rather than become a tramp or 
beggar, is almost nothing at all; and it takes only a rela- 
tively slight rise in that price to set him working full time. 
The height of s^ represents the price at which he will work 
the greatest number of hours. Above this he will prefer 
slightly shorter hours. As already stated, it is probable 
that the eight-hour movement to-day is partly due to the 
fact that wages are high enough to enable the laborer to 
afford some leisure instead of being so low as to " keep 
his nose close to the grindstone." 

A reduction in wages v/orks in the opposite way, making 
workmen willing to work longer hours and for lower wages. 
Only when the price falls much below the elbow at / will 
they refuse longer to endure the low wages and long hours. 
They will then prefer, if not to starve, to throw themselves 
upon the mercy and charity of the community. The 
general level of the curve between the elbow s^ and the 
beginning ^ represents their minimum standard of living 
which they require if they work at all. 

Now, if wages keep high and the workmen have a suffi- 
ciently low " rate of impatience " to enable them to accu- 
mulate savings, they become more '' independent," which, 
as applied to their supply curves s s^ s'^ means that it 
shifts a little toward the rich man's supply curve s / s'^. 



WAGES 377 

The result is a higher minimum wage necessary to induce 
the laborer to work and a lower maximum number of hours 
which he is willing to work. The intersection with the de- 
mand curve will therefore be higher and farther to the left ; 
that is, the market rate of wages will be higher and the hours 
worked fewer. 

This result is not due to any reduction in the number 
of workmen, but simply to a reduction in their desire for 
more money. Savings, therefore, making workmen more 
independent and less necessitous, will — by lessening their 
desire for money — both increase their wages and shorten 
their hours. 

A second peculiarity in regard to wages is that, except 
under slavery, the earnings of a laborer are seldom dis- 
counted so as to ascertain his capital- value. The reason for 
making an appraisement usually has reference to some pro- 
posed sale ; and, as working men and women are no longer 
for sale, their capital-value is seldom computed. For this 
reason, wages, unlike rent, are not often regarded in the 
light of interest on the capital- value of the men who earn 
them. 

A third peculiarity of wages is one already alluded to, viz. 
that in practice they are always reckoned as gross and 
never as net. This is because the wages are reckoned from 
the standpoint of the employer who pays them, and not of 
the laborer who receives them. Under slavery the case 
was different, and the net income earned by a slave was 
computed in the same way as the net income earned by a 
horse — by deducting from the value of the work done the 
cost of supporting the slave. But under the system of free 
labor which now prevails the employer has no such cost. 
The laborer assumes his own support, and furnishes only his 
work to the employer. The net wages of the laborer, if they 
are to be computed at all, are to be found by allowing for 
the irksomeness of his work i.e. the real costs which he 
bears of labor and trouble. At the margin — that is, for 



378 ELEMENTS OF ECONOMIC SCIENCE 

the last unit of work done — this cost is, as we have seen, 
equal to the wages received for it ; but on all earlier units of 
work there is a gain of desirability which can be appraised 
in money. The net v^^ages thus reckoned will be only a part 
of the wages as ordinarily quoted. 

When, therefore, we compare the $500 a year which a 
workman gets by selling his work with the $500 a year 
which a bondholder gets as interest, we must not forget 
that the workman's $500 is really less valuable than the 
bondholder's $500, and for two reasons. One is the reason 
just given, that the workman's $500 is obtained only by 
the sweat of his brow, while the bondholder's is all clear 
gain ; the other reason is that the workman's $500 will cease 
at his death or disablement, while the bondholder's goes on 
forever. 

A fourth peculiarity concerning wages is that the supply 
of wage earners differs from the supply of any other instru- 
ment. Except in slavery, workmen are not bred like cattle 
on commercial principles. A rise in the price of the serv- 
ices of a draft horse will increase the demand for draft 
horses, and the result will be that both the market price 
and the amount supplied at that price will be increased. 
Those who supply draft horses will breed them to take 
advantage of the higher prices of them and their services. 
A rise in the price of human services will not act so simply. 
It is true that a rise in wages usually increases the number 
of marriages and often increases the birth rate, but such is 
not always or necessarily the result ; and even when births 
do increase in number, they do not increase to exactly the 
same extent as draft horses are bred. It is an excep- 
tional father who can think or say as did a cynical old farmer 
who had raised a large family and thriftily turned their 
child labor to early account for his own benefit : " My 
children have been the best crop I ever raised." Ordinarily 
parents view their children not as potential earning power 
but as objects of affection, and either do not attempt to 



WAGES 379 

regulate their numbers, or do so with reference to considera- 
tion for their own or their children's comfort. The prin- 
ciples which regulate the number of laborers are part of the 
principles regulating population in general, and will be con- 
sidered in the next chapter. 

§ 3. The Demand for Labor 

Turning now from the supply to the demand side of the 
market, we find that the demand of employers for workmen 
is in general quite analogous to their demand for the serv- 
ices of land or any other productive agent. Sentiment and 
humanity have a little inJ&uence, but not enough to require 
special attention on our part. Wages are paid by the or- 
dinary employer as the equivalent of the discounted future 
benefits which the laborer's work will bring to him, — the 
employer, — and the rate he his wilKng to pay is equal to 
the marginal desirabihty of the laborer's services measured in 
money. We wish to emphasize that the employer's valua- 
tion is (i) marginal, and (2) discounted. The employer pays 
for all his workmen's services on the basis of the services least 
desirable to him, just as the purchaser of coal buys it all on 
the basis of the ton least desirable to him; he watches 
the " marginal " benefits he gets exactly as does the pur- 
chaser of ccal. At a given rate 01 wages he " buys labor " 
up to the point where the last or marginal man's work is 
barely worth paying for. This marginal unit of work is 
a sort of barometer of wages. 

Secondly, wages which the employer pays are the dis- 
counted value of the future benefits he receives. Thus, the 
shepherd hired by the farmer to tend the sheep in the pas- 
ture renders benefits the value of which to the farmer is 
estimated in precisely the same way as the value of the 
benefits of the land which he hires. It follows that the 
rate of wages is dependent upon the rate of interest. 

A rise in the rate of interest will produce a fall in the 



380 ELEMENTS OF ECONOMIC SCIENCE 

rate of wages by lowering the discounted value of the 
services of workmen, and therefore lowering the prices 
which suppHers are willing to pay. Contrariwise, a fall in 
interest produces a rise in wages. 

Conformable to the previous reasoning, the dependence of 
wages on the rate of interest is the more pronounced, the 
more remote are the ultimate benefits to which the work of 
the laborer leads. In a community where the workmen are 
largely employed in enterprises requiring a long time, such 
as digging tunnels and constructing other great engineering 
work, the rate of wages will tend to fall appreciably with a 
rise in the rate of interest, and to rise appreciably with a 
fall in the rate of interest ; whereas in a country where the 
laborers are largely engaged in personal service or in other 
work which is not far distant from the final goal of enjoy- 
able benefits, a change in the rate of interest will affect the 
rate of wages but shghtly. 

Moreover, a change in interest will divert laborers from 
one employment to another. If interest rises, it will 
divert labor from enterprises which require much time and 
in which, therefore, the high interest is a serious considera- 
tion, and turn it into enterprises which yield more immediate 
benefits. For example, the higher the rate of interest, the 
less relatively will laborers be employed in constructing 
great canals and the more relatively will they be employed 
as domestic servants, and vice versa. 

We have now considered wages under <^onditions of com- 
petition. Under competition they are determined — hke 
any other competitive price — by the famihar principles 
of supply and demand. If, instead of competition, we 
have conditions of more or less perfect monopoly, the 
principles of wage determination will change accordingly 
and in the manner previously explained, for monopoly. 
If employers form combinations called trusts, or if laborers 
form combinations called trades unions, there will be an 
effect on the rate of wages. These combinations tend to 



WAGES 381 

render bargaining collective instead of competitive, and the 
efforts on the two sides of the market take the form of 
struggles called strikes and lockouts. The fuller considera- 
tion of these subjects belongs to applied economics. 

§ 4. General Influences on Rents and Wages 

The sum of all the rents and wages, exphcit and impKcit, 
in any community is, of course, the total income of that 
community. An inventory of rent and wages would show 
what quota was contributed to this total by human beings, 
land, and other instruments. It would be simply a list of 
the net incomes from all these. By far the larger part is 
contributed by human beings. Professor Nicholson of 
Edinburgh has estimated that in England the income earned 
by what he calls " the living capital " of Great Britain is 
five tim^es as great as that earned by the " dead capital." In 
less wealthy countries the preponderance of man-produced 
income is probably still larger. Of the part produced by 
" dead capital " the larger portion is from land. A state- 
ment of the parts of total income due to various agents, such 
as laborers, land, and other capital which together yield 
that income, constitutes the distribution of income rela- 
tively to the capital which produces it. 

It should be noted that though each of the various labor- 
ers, lands, and other instruments which jointly produce 
income, is credited with a certain part, it could not produce 
this part alone, or by itself. The earnings of a railway are 
due, for instance, to the joint work of the locomotive, cars, 
roadbed, terminals, and employees. These are not inde- 
pendent but mutually completing instruments, and their 
ser\'ices are completing services. We impute to each a 
certain part, determined according to the principles which 
regulate the prices of completing goods. 

In a new country the rent of land is apt to be low, but rent 
of other things and wages high. For in such a country land 



382 ELEMENTS OF ECONOMIC SCIENCE 

is abundant, but other forms of capital, including laborers, 
relatively scarce. As a country grows older and more popu- 
lous, land rent tends to rise, and other rents and wages to 
faU. 

Progress in scientific knowledge causing an increase in 
productivity of land is like the rejuvenation of a country. 
Any increase in general productivities, whether of land or 
of other agents of production, has a tendency to make the rate 
of wages increase; for (i) by increasing the wealth of em- 
ployers, and thereby diminishing the marginal desirabihty 
of money, there is a tendency to increase their demand for 
everything, including the services of workmen ; and (2) so 
far as workmen themselves are owners of houses, imple- 
ments, and other instruments of any kind, and thus share in 
the increased afSuence, the supply of work they offer is 
decreased, as we have seen. 

Such a result is probably the chief general effect of so-called 
labor-saving machinery. It increases the income of other 
classes than laborers, and with it their power to buy work of 
laborers. The first effect, however, is for the labor-saving 
machine to displace laborers, with which, in fact, they are 
competing articles, and we have seen that the increase in 
one of two comxpeting articles or substitutes tends to lower 
the price of the other. The individual laborers thus dis- 
placed are Hkely to be injured by the improvement, being 
unable to learn another trade without undue loss of time. 
It is even conceivable that labor-saving machinery might 
become so automatic and so fully a substitute for human 
work that there would be no need and no demand for such 
work. But such an effect seems very improbable. The 
human machine is so much more versatile than other ma- 
chines, its competing with labor-saving machines is not as 
important as its completing them. As a matter of history, 
so-called labor-saving machinery, while it " saves " or dis- 
places laborers from one sort of work, often if not usually 
produces new needs for them in another sort of work. If 



WAGES 383 

horses and carriages were introduced into China, they would 
largely dispense with the need of cooHes, who now carry pas- 
sengers in sedan chairs, but they would call for coachmen and 
grooms. When in turn stage coaches give place to railways, 
the trade of drivers of stage coaches becomes obsolete, but 
the new trades of locomotive engineers, firemen, conductors, 
and brakemen are created. In fact, the very names of these 
occupations, as of hundreds of others, show that the demand 
for these sorts of work arises from the existence of machinery. 
In other words, labor-saving machinery, while, as its name 
impHes, is always a competing article with the human 
machine with respect to some of its many-sided capacities, 
usually also is a completing article with respect to some 
other capacity; and we have seen that an increase in the 
quantity of one of two completing articles tends to increase 
the price of the other. 

But while a general increase in the incomes enjoyed by a 
community usually tends to increase the rate of wages, an 
increased inequality of incomes may have the reverse effect. 
At any rate, a decrease in the amount of capital which la- 
borers own will, as we have already seen, make them wilhng 
to take lower wages than otherwise. In fact, the chief 
reason that there exists a wage class is that those consti- 
tuting it have httle or no capital apart from their own per- 
sons. Wage earners are chiefly " propertyless " persons, 
persons who either never had or inherited any property, or 
who lost what they did have, as, for instance through too 
high a " rate of impatience." We see, therefore, that the 
question of wages depends, among other things,on the dis- 
tribution of the ownership of wealth. This will be the 
subject of the next chapter. 



CHAPTER XXV 

OPULENCE AND POVERTY 

§ I. The Problems of Opulence and Poverty 

In the two preceding chapters we have considered the dis- 
tribution of income relatively to the agents or instruments 
which produce income. In the present chapter we shall co- 
nsider the distribution of this same income relatively to 
those who own and enjoy it. The two sorts of distribution 
are quite different, although there has been a tendency to 
confuse them. This was natural, for in the early days of 
economics people were classified roughly according to the 
sort of instruments they owned. There was the landlord 
class, whose chief income was ground rent, the non-landed 
capitalist, whose chief income was from other capital than 
land, and the laborer, whose chief income was wages. It 
was then natural to imagine that the incomes produced by 
laborers, by land, and by other capital, were also the in- 
comes enjoyed by laborers, by landlords, and by other 
capitalists. But even were such a classification possible 
and duly made, it would still fail to tell us anything what- 
ever as to how large was the per capita share within each 
class, or whether the amounts enjoyed by different individu- 
als were or were not very unequal. The best we could say 
would be that certain land yields a rent of $io an acre, and 
other lands more or less than this; that certain houses 
rent for $1000 a year, and others for more or less; that 
money lenders make 5 per cent on their loans; and that 
ordinary wage earners get $2 a day. But these data, 
however detailed, would not tell us the actual income en- 
joyed by any single person, except in the case of the laborer, 

384 



OPULENCE AND POVERTY 385 

and then only on the assumption that he derived no income 
from any other source than from his work. Furthermore, 
to-day there are only small traces left of the old social strati- 
fication, and correspondingly little excuse for confusing the 
distribution of income by the capital which yields it and by 
the persons who own it. 

But, though the two sorts of distribution are distinct, 
each is needed to understand the other. The last two 
chapters were devoted to the first sort of distribution, and 
have prepared us for the study of the second sort. 

The problem now before us — distribution relatively to 
owners — may be described as the problem of the total 
income, the average income, and the relative numbers of 
people owning incomes of various sizes. The last-named 
part of the problem is the problem of grading the population 
according to income — the problem of discriminating the 
relatively rich and poor. No other problem in economics has 
as great a human interest as this, and yet scarcely any other 
problem has received so little scientific study. 

Since income necessarily comes from capital, — at any 
rate if human beings be included, — the '' distribution " of 
income is likewise the ^' distribution " of capital. Our 
problem may therefore be stated either as the problem of 
the personal distribution of income or that of the personal 
distribution of capital. Still more simply it is the problem 
of " the distribution of wealth." 

For the purpose of comparing the wealth of different 
persons or nations, values are more important than quan- 
tities. If we know that Mr. A's income is worth $1000 a 
year and Mr. B's $10,000, we may say that Mr. B's income 
is ten times Mr. A's in the sense that the elements compos- 
ing B's income are worth in exchange ten times the elements 
composing A's income ; or if we know that X is " worth '* 
{i.e. owns capital worth) $1,000,000 and that Y " is worth '' 
$10,000,000, we may say in like sense that Y's capital is 
tenfold X's. 



386 ELEMENTS OF ECONOMIC SCIENCE 

In order to compare the incomes or capitals of widely 
distant times or places, a correction may need to be made 
for difference in the purchasing power of money, and if the 
rate of interest is also different in the two cases, the cor- 
rection will not necessarily be the same for the capital as 
for income. A millionaire worth $1,000,000 in California 
half a century ago, the rate of interest being 12 per cent, 
commanded an income equivalent to that of a multimil- 
lionaire to-day, worth $3,000,000, for the present rate of 
interest is only one third as high. Another point of differ- 
ence between comparisons of capital value and comparisons 
of income value lies in the fact that while capitalv alues 
differ only in size, income values differ also in time-shape 
and certainty. For this reason a man rich in lands from 
which there is little immediate inccme — but only prospects 
of income in the distant future — is sometimes called '' land 
poor," having much land but little immediate income. 

But when, instead of comparing the wealth of different 
persons or nations, we are seeking to compare the absolute 
comforts they enjoy, it is more important to consider quan- 
tities than values. In fact, as noted at the outset of our 
study, money valuations are apt to be misleading. A 
country where water is scarce will have a higher money 
valuation on its water supply than a country where water 
is so abundant as to have no price. Thus, a large quantity 
of water shows more affluence in the sense of comfort than 
does a large value of water. 

Practically, however, if we confine our attention to 
modern times and conditions in Western Europe and 
America, it is true, in a general way, that of two nations 
or individuals the one which is richer in capital goods is 
richer also in capital- value, in income goods and in income 
values. For simplicity we shall hereafter assume that 
these four comparisons are thus similar. We may say 
that a m.an is " rich " if he has a large amount of capital 
goods of various kinds — lands, houses, stocks, bonds, etc. ; 



OPULENCE AND POVERTY 387 

or a large money value of capital goods ; or a large amount 
of benefits of various kinds — nourishment, clothing, shel- 
ter, amusements, etc. ; or a large money value of benefits 
of these kinds. 

A man is " poor " if he has small amounts of all these 
things. 

Of course the two terms " rich " and " poor " are purely 
relative, and represent no deeper scientific meaning. A man 
who is rich according to one standard may be poor accord- 
ing to another. But the two terms are very convenient to 
designate relative conditions. Corresponding to the ad- 
jectives '^ rich " and " poor " are the nouns " opulence " 
and " poverty." Our subject, then, in this chapter is com- 
parative opulence and poverty, both of nations and of 
individuals. 

§ 2. National Opulence or Poverty 

We may divide this subject into two heads : the opulence 
or poverty of nations and the opulence or poverty of indi- 
viduals. First as to the opulence or poverty of nations. 
*' The wealth of nations" is composed of three things, — its 
people, its lands, and the capital the people have produced 
from the land. These three items of which capital is com- 
posed are mentioned in order of relative importance. The 
income earned by the people of a nation always far exceeds 
the income earned by all its other wealth. Yet people do 
not earn income without at least land. Given laborers 
and land, we have the only two real requisites of producing 
income. Other capital springs from these two. It is some- 
times said labor is the father, land the mother, and the 
other kinds of capital the children. A nation, then, is the 
richer, the larger the number of its inhabitants, the greater 
the extent of its territory, and the greater the amount of its 
accumulated products. These three groups or classes of 
capital depend each on somewhat different conditions. 



388 ELEMENTS OE ECONOMIC SCIENCE 

The amount of land and its power to produce is largely a 
question of natural resources. It may be taken as a given 
quantity presented to man by nature. It is now becoming 
recognized, however, that land is not so definitely constant 
in its power to produce as was once imagined. One of the 
most important results of the recent '' conservation move- 
ment " in this country is to show conclusively that land is 
not altogether a constant source of income, but that it is 
possible by the impoverishing and washing away of top soil 
to greatly impair or destroy absolutely the productivity of 
land ; while on the contrary by proper fertilization, keeping 
land fallow, rotation of crops, etc., it is possible to increase 
the efficiency of land just as it is possible to increase the 
efficiency of other instruments. 

The dominion over land by any given group of men may 
depend on wresting it by mihtary force from another group. 
In fact one of the chief objects of w^ar has been to increase 
national wealth by adding to territory. This was a chief 
object of the Roman Empire and of the colonial system of 
Great Britain. These and other nations have had w^hat is 
called " earth hunger." The wealth of the British Em^pire 
to-day hes for the most part outside of the British Isles ; 
for England owns India, Canada, AustraHa, and parts of 
Africa. Except for the war of the Revolution, she would 
now be owning the territory occupied by the United States. 

The number of inhabitants in the nation depends in turn 
upon the extent of the territory as also on the past history 
of the nation and on other conditions which will be con- 
sidered later in this chapter. IMany nations have sought 
to increase their wealth and power by increasing their 
population. In fact, the chief reason for extending a na- 
tion's territory has been to fill it with colonists. A country 
is usually alarmed at the prospect of a stationary or de- 
creasing population. France is now trying to conserve its 
population, recognizing that national strength for future 
wars or for future poHtical position among the nations of 



OPULENCE AND POVERTY 389 

the earth depends largely on the numbers of fighters and 
of workers. The productiveness of these people as well as 
the productiveness of the lands they keep will depend 
largely upon their condition as to vitality and accumulated 
knowledge. 

We come last to the amount of accumulated products. 
This depends on two chief quahties, first those causes like 
thrift which we have seen lead to saving, and second inven- 
tion which has led to the creation of income-producing 
instruments. 

§ 3. Per Capita Opulence or Poverty 

So much for the conditions determining the opulence of 
nations. We may pass now to the more important subject 
of opulence or poverty of individuals. This subject may 
be divided into two parts : the study of average or per 
capita wealth, and the study of its distribution or the rela- 
tive opulence and poverty among different individuals. By 
the per capita wealth of any nation is meant the quotient 
found by dividing the total wealth by the number of in- 
habitants. It is evident that two nations may compare 
very differently as to aggregate and as to per capita wealth. 
The small countries, Holland and Switzerland, when com- 
pared with the large countries, India and China, are far 
poorer in aggregate wealth, but far richer in per capita 
wealth. The per capita wealth in any nation will thus 
increase with an increase in the total wealth and decrease 
with an increase in population. 

With the advent of Democracy in politics has come a 
greater emphasis on per capita as compared with aggregate 
wealth. Under autocracies the aim was to increase the 
wealth of the nation as a whole, partly for the personal 
aggrandisement of the autocrat or potentate, who often re- 
garded himself as a sort of owner of the nation (" Vetat, 
c^est moi "), and partly because the sentiment of nationa 



390 ELEMENTS OF ECONOMIC SCIENCE 

greatness was satisfied in this way. Under these con- 
ditions an increase in population was almost invariably 
vv^elcomed and encouraged. But since the individuals of 
the nation have become its rulers and, so to speak, share- 
holders, they have regarded increase of numbers with mixed 
feelings ; for while on one hand they welcome an increase 
in the total wealth which a greater population : brings, they 
do not reHsh a decrease in the per capita wealth which may 
ensue. In the Democratic ideal, therefore, an increase of 
population is usually welcomed only in a new country where 
there is plenty of land, or in a country acquiring colonies to 
provide room for a surplus population. 

The effect of an increase of national wealth on per capita 
wealth will evidently depend upon the ratio between land 
and population. In a sparsely settled country an increase 
of population will not only increase the aggregate, but the 
per capita wealth. When, however, the country is settled 
and filled up with population to a certain point, the opposite 
becomes true and a fresh increase of population, while 
continuing to increase aggregate wealth, will decrease per 
capita wealth. This fact sets a sort of elastic limit to an 
increase of population. That there must be such a limit 
is evident since an indefinite number of people cannot be 
supported on one acre of land. We know as a generaliza- 
tion from ordinary observation that the billion and a half 
people now hving on this planet could not be supported if 
all packed into the state of Rhode Island and dependent on 
Rhode Island for sustenance. Per capita poverty would 
then be so intense that people would die of actual starva- 
tion. Long before such a starvation point is reached, every 
increase of population beyond a certain point results in an 
increased death rate. In fact, statistics show that the 
death rate increases as per capita wealth decreases. This 
fact is due to the unsanitary conditions which poverty neces- 
sarily brings, conditions not so much with respect to the 
quantity of food as with respect to its quality and with 



OPULENCE AND POVERTY 391 

respect to the quantity and quaKty of housing and other 
comforts and conveniencies of Kfe — and perhaps above 
all with respect to conditions of employment, especially 
hours of labor. We have, then, ample evidence that when 
the ratio of population to land becomes excessive, the 
death rate is increased, and consequently a further increase 
of population is injurious to the individual. 

When population is sparse, the opposite is true. The 
history of new countries shows that an increase in popula- 
tion is a blessing as well individually as collectively. 

This law of per capita wealth is chiefly based on the 
anterior fact that land is an essential agent in production 
and that each successive increase in the productivity of land 
is acquired at increasingly great cost — or, expressed other- 
wise, that with each successive increase in cost, the return 
diminishes. This is the law of diminishing returns in 
agriculture. There is then, based on facts, a general law 
of per capita wealth in relation to population. It may be 
stated as follows : Given a particular stage of knowledge 
and of the arts and of other conditions that determine pro- 
ductivity, an increase of population first increases and 
then decreases the per capita wealth. 

§ 4. Principles of Population 

The population of any country may be increased either 
by births or immigration and decreased by deaths or emi- 
gration. The population in general, as a whole, can be in- 
creased only by births and decreased by deaths. As we are 
more interested in general than in local increases or de- 
creases in population, we may overlook the questions of 
emigration and immigration, assuming for the area under 
consideration that they are either absent or balance each 
other. 

With this proviso, we may say that the population of a 
country will decrease if the death rate exceeds the birth rate 



392 ELEMENTS OF ECONOMIC SCIENCE 

and will increase if the birth rate exceeds the death rate. 
As we have already stated, the facts show that the death 
rate increases with a decrease in per capita wealth. The 
birth rate remains to be considered. When Malthus wrote 
his famous "Principle of Population," it was in general true 
that an increase in per capita wealth produced an increase 
in the birth rate. To-day this is true only to a certain ex- 
tent. We shall for the moment, however, assume it to be 
universally true. Under these conditions we may say that 
an increase in per capita wealth tends to increase the birth 
rate and to decrease the death rate, and that a decrease 
in per capita wealth tends to increase the death rate and to 
decrease the birth rate. 

If we assume what history has almost invariably shown 
to be the fact, that in a sparsely settled country the birth 
rate exceeds the death rate, so that the population tends at 
first to increase, we are now in a position to state what will 
happen to the population of that country in future genera- 
tions, quite apart from any increase in immigration. By 
hypothesis the population will increase at first and, as at 
first each increase in population brings an increase in per 
capita wealth, it will continue to increase as long as this 
condition continues. But as we have seen, it will ultimately 
happen that per capita wealth will cease to increase and will 
begin to diminish. It will then happen that the death 
rate will increase and the birth rate decrease, so that the 
increase of population will be slackened and ultimately 
cease altogether. Under these conditions, then, a new 
country will be filled with population up to a certain point 
at which it will cease. The population is then in a sort of 
equihbrium, the birth rate equahng the death rate because 
the per capita wealth has been reduced to such a point as 
to bring this equilibrium about. 

The law of population therefore may be stated as fol- 
lows: Assuming that in a sparsely settled country the 
population will at first increase, and knowing that as the 



OPULENCE AND POVERTY 393 

per capita wealth decreases the death rate will increase, and 
the birth rate decrease and therefore the rate of increase 
of population slacken and ultimately terminate, we have 
an increase of population followed by stationary population, 
the stationary point representing an equality between the 
birth rate and death rate because people are either unable 
or unwilling to lessen the rate of subsistence thus reached. 

This limit on human population is the same Hmit which t 
nature sets on animal and plant population. Blades of 
grass multiply until they cover the ground on which they 
grow. When grass is sown on a grass plot, it multiphes 
with great rapidity, but after the whole plot is covered and 
there is no room for more, the number of blades remains 
nearly stationary. There is a struggle for life constantly 
going on and the death rate thus produced is great enough 
to balance the birth rate which the capacity of the soil 
allows. Out of this struggle for existence among animals 
and plants comes what Darwin calls natural " selection," 
and it is interesting to know that Darwin's first idea of such 
a struggle came from reading Malthus on Population. 
Population is then said to be Hmited by subsistence. 

Since Malthus's day, as a consequence of his doctrines 
and advice, there has come into more definite operation 
what he called the " voluntary check " on population. 
While it is still true that among the poor it usually happens 
that an increase in per capita wealth tends to increase the 
birth rate by encouraging marriages or making them earlier 
or increasing the number of children per marriage, it has 
become unfortunately true that among the wealthier classes 
an increase in wealth tends sometimes in the opposite direc- 
tion. Instead of wealth being then thought of as a means 
of supporting children, it comes to be thought of as a chief 
end in fife, and the more of it gained the more ambitious 
are its possessors that its enjoyment may not be interfered 
with by childbearing, or that it shall not be decreased by 
subdivision in the next generation. The result is that the 



394 ELEMENTS OF ECONOMIC SCIENCE*, ^ 

wealthier classes often have, on the average, smaller famihes 
than the poorer classes. We must, therefore, modify the law 
of population so as to read that an increase in per capita 
wealth instead of tending always to increase the death rate 
tends first to increase it and then to decrease it. This wealth 
check to population is pecuHar. It is quite different from 
the poverty check. The poverty check works automati- 
cally so as to check population when it is too large and not 
to check it when it is too small. But the wealth check acts 
in the opposite way — or rather it would do so if it were 
sufficiently strong and general, which is not yet the case. 
Then it would come about that the greater the per capita 
wealth the more would population be checked, and as the 
check to population usually tends to increase per capita 
wealth, this would still further decrease population. The 
logical result is depopulation or ''race suicide." 

At present however, this wealth check is confined to 
certain parts of the population and results, for those parts 
only, in " race suicide." These parts include particularly 
the so-called " better classes " of the population. Children 
of college graduates are less numerous than the graduates 
themselves. Thus, besides depopulation, there is another 
danger, degeneration. If the vitahty or vital capital is im- 
paired by a breeding of the worst and a cessation of the 
breeding of the best, no greater calamity could be imagined. 
But while the risk of such a result undoubtedly exists, this 
is not immediate, and an increasing realization of its pos- 
sibility, we may hope, will lead to some way of counteracting 
it. A method of producing the contrary result — namely, 
producing from the best and suppressing from the worst — • 
has been suggested by Sir Francis Galton under the name of 
''eugenics." 

§ 5. Distribution of Wealth 

Having considered aggregate and per capita wealth, we 
come finally to the distribution of wealth among different 



OPULENCE AND POVERTY 395 

individuals. Although a whole nation may be rich or poor 
relatively to another nation, the widest differences between 
nations are small as compared with the differences within 
any one nation. Every nation has its extremely poor, its 
extremely rich, and its classes in intermediate states. In 
the United States there are many wage earners who can- 
not earn $i a day and who have no income except what they 
earn by labor, while at the opposite extreme are the multi- 
millionaires who receive incomes of over $1,000,000 a month. 

What are the reasons for such prodigious inequahties in 
the personal distribution of wealth? Are such inequahties 
injurious? If so, are they preventable? If so, by what 
means? These are some of the mosjt burning questions of 
the day. Out of them spring many reform movements, 
and especially sociaHsm. But these, like other practical 
problems, are applications of economic principles, and 
cannot be discussed in a book designed to treat only of 
economic principles themselves. Sufhce it to say that no 
proper answer can be made to the last question of how to 
cure the unequal distribution of wealth until we have an- 
swered the first question of what causes this unequal dis- 
tribution. As often happens, more study has already 
been devoted to cure than to diagnosis, and with the usual 
ineffective result of quack remedies. 

Our present object will be to set forth the causes which 
affect the relative personal distribution of wealth. What- 
ever these causes may be, they are evidently fundamental 
and universal; for we find that extremes of poverty and 
riches have existed at all times and places. They are men- 
tioned in the Bible and other histories of peoples in all ages 
and stages of civilizations. It is probable that the degree 
of inequahty differs as between the Oriental civihzations, 
like China and India, and the Occidental, like England and 
France, and also as between the older nations of western 
civilization hke Russia and Italy, and the younger, Uke the 
United States and Canada. But the fact and the causes 



396 ELEMENTS OF [ECONOMIC SCIENCE 

are nearly the same everywhere. Distribution differs, it 
is true, according to political institutions, as, for instance, 
between Germany and England. There is a comparative 
absence of extreme poverty in Germany as contrasted with 
England and the United States ; and a comparative preva- 
lence of poverty in Russia and Italy; and a comparative 
frequency of extreme opulence in Holland. Professor Pareto 
has found that, as between different countries, for which 
statistics are available, and as between various periods of 
time, the statistical inequalities in the distribution of wealth 
have maintained a remarkable correspondence, more close, 
in fact, than statistics of mortality. 

The causes which have produced the present inequalities 
r/of wealth are largely historical, that is, lie in the past. It 
usually takes more than one generation to affect greatly the 
economic standing of a family. For this reason some people 
have foolishly imagined that if to-day we could once correct 
the inequalities in wealth handed down to us from the past, 
the problem would be solved, and with a new and even start 
we would be forever rid of great poverty by the side of great 
wealth. We shall soon see, however, that if wealth were 
once equally divided, it would not stay so. The analysis of 
what would happen will serve as the best introduction to 
our study of distribution. 

§ 6. Equality of Distribution an Unstable Condition 

Let us suppose that, through some communistic or social- 
istic law, the wealth in the United States were divided 
with substantial equality. It is proposed to show that , 
this equahty could not long endure. Differences in thirft/ 
alone would reestabhsh inequahty. We cannot suppose 
that human nature could be so changed and become so 
uniform that society would not still be divided into " spend- 
ers " and " savers," much less that different people would 
all spend or all save in exactly the same degree. So long 



OPULENCE AND POVERTY 397 

as there are any differences whatever between people in 
regard to their '' rates of impatience " under hke conditions, "~ 
there will immediately ensue differences in saving or spend- 
ing. It requires only a very small degree of saving or spend- 
ing to lead to comparative opulence or poverty, even in one 
generation. It is remarkable how much may be saved in a 
lifetime by thrift. Cases are sometimes found of day 
laborers who, by saving and putting at interest, accumulate 
within a lifetime a small fortune, and in the meantime rear 
a family. As Micawber said, a m^an with an income of one 
pound a week will reach poverty if he spends just one penny 
more, and reach opulence if he spends just one penny less. 

The larger the amounts saved or spent, the more rapidly 
is a fortune gained or lost. As we have seen, the process 
by which individuals thus gain or lose fortunes by saving 
or spending consists, in the last analysis, of an exchange 
of present and future income. If two men have to start 
with the same income of $1000 a year, but one has a rate of 
time-preference above the market rate of interest and the 
other has a rate below, the first will continue to get rid of 
future income for the sake of its equivalent in immediate 
income, and the other to do exactly the opposite. Such 
substitutions of immediate for remote, and of remote for 
immediate, income may take place by means of loans, sales, 
or changed uses of capital. The man with spendthrift ten-"" 
dencies will borrow, i.e. pledge future income for the sake of 
present income ; or he will sell any durable goods which 
offer remote income, such as farms or forests, and buy 
perishable goods which offer immediate income, such as 
champagne, clothing, horses, and carriages ; or he will 
change the uses to which he puts his capital, avoiding those 
which require improvements, and choosing instead those on 
which he can realize quickly, thus letting his property 
run down. 

The man with saving tendencies, on the other hand, will 
lend or invest present incom^e for the sake of future, will 



398 ELEMENTS OF ECONOMIC SCIENCE 

sell perishable and buy durable goods, and will make far- 
sighted uses of his capital. As we have seen, both men 
will pursue their respective pohcies up to the point where 
their marginal rates of impatience harmonize with the rate 
of interest. 

As we have seen, the rates of impatience among different 
individuals are equahzed in these ways. In the case of an 
individual whose impatience to reduce income is unduly 
high, we found that generally he contrives in some way to 
modify his income-stream by increasing it in the present at 
the expense of the future. We were then intent on study- 
ing this phenomenon only on the side of income; but the 
effect on capital can be easily seen by applying the prin- 
ciples of Chapter VII. If a modification of the income- 
stream is such as to make the present rate of realized income 
exceed the " standard," capital is being depleted to the ex- 
tent of the excess, and the person will grow poorer. Indi- 
viduals of the type of Rip Van Winkle, if in possession of 
land and other durable instruments, will sell or mortgage 
them in order to secure the means for obtaining enjoyable 
services more rapidly. The effect will be, for society as a 
whole, that these individuals who have an abnormally low 
appreciation of the future and its needs will gradually part 
with the more durable instruments, and that these will 
tend to gravitate into the hands of those who have the 
opposite trait. 

The central role is thus played by the rates of preference 
for present over future income and the rate of interest. The 
existence of a general market rate of interest to which each 
man adjusts his rate of preference supplies an easy highway 
for the change in his capital in one direction or the other. 
If an individual has spendthrift tendencies, their indulgence 
is facilitated by access to a loan market ; and reversely, if 
he desires to save, he may do so the more easily if there is a 
market for savings. The irregularities in the distribution of 
capital are thus due in part to the opportunity to effect 



OPULENCE AND POVERTY 399 

exchanges in the parts of the income-stream located at dif- 
ferent times. The rate of interest is simply the market 
price for such exchanges. By means of this market price, 
both those who wish to barter present for future income and 
those who wish to do the reverse may satisfy their desires. 
The one will gradually increase, and the other gradually 
diminish, his capital. If all individuals were hermits, it would 
be much more difficult either to accumulate or to dissipate 
fortunes, and the distribution of wealth would therefore 
be much more even. Inequality arises largely from the 
exchange of income, carrying some individuals toward 
wealth and others toward poverty. In short, the in- 
equality of wealth isfacihtated by the existence of a loan 
market. In a sense, then, it is true, as the socialist main- 
tains, that inequahty is due to social arrangements ; but 
the arrangements to which it is due are not, as he assumes, 
primarily such as take away the opportunity to rise in the 
economic scale. On the contrary, they are arrangements ] 
which facihtate both rising and falHng, according to the 
choice of the individual. The improvident sink hke lead 
to the bottom. The provident rise to the top. 

But thrift, important as it is, is not the only road to 
wealth, nor thriftlessness the only road to poverty. Besides 
differences in the rates of time-preferences, there are equally 
potent differences in abihty, industry, luck, and fraud. 
By ability is meant one's capacity to earn, by industry the 
use of this capacity. Examples of getting rich from abihty 
and industry are very common. Almost all the rich men 
in this country who have made their fortunes have done so, 
in part at least, through abihty and industry. Often luck 
has added greatly. There are many examples of miners 
who got rich in Colorado by simply stumbhng on a 
gold mine. Luck plays a larger role in the accumulation 
of fortunes than many are incHned to believe. The '' un- 
earned increment " is usually a case of luck. Unforeseen 
increase in ground rents has often given rise to large for- 



400 ELEMENTS OF ECONOMIC SCIENCE 

tunes from time immemorial. It is also unfortunately 
true that some men have really got their start, if not their 
larger accumulations, through fraud. This has sometimes 
occurred through " high finance," which consists very largely 
in making contracts with one's self. If a man can own or 
control the majority stock in a corporation, and then make 
a contract to buy materials of himself at any price he 
sets, he naturally can make money. Also through poHtical 
" graft," and especially through getting city franchises for 
gas and waterworks and street car companies, and through 
special tariff legislation, many men have become wealthy. 
Poverty, on the other hand, has often resulted not only from 
thriftlessness, but from incompetence, i.e. lack of abihty, 
slothf ulness (lack of industry) , and misfortune or bad luck, 
and from having been defrauded by others. 

We conclude, therefore, that equality of wealth is an un- 
stable^ condition and, even if once estabhshed, would not 
endure, because of the unequal forces of thrift, ability, 
industry, luck, and fraud. 

/ But inequality once established tends, by inheritance, 
to perpetuate itself in future generations. The workman 
who accumulates a few thousand dollars from nothing 
makes it easier for his children to accumulate more. He 
gives them a start or a '' nest egg." Recently four sons 
of a Connecticut farmer met in a family reunion. Many 
years ago the father had sent them into the world to make 
their fortune, giving each $700 to start with. When they 
met at the recent family reunion, all were worth thousands. 
Hetty Green is an example of a person who inherited a large 
fortune and then accumulated, by her low " rate of impa- 
tience " or preference to accumulate for the future rather 
than to spend in the present. A fortune of $6,000,000 was 
bequeathed her, and now her fortune is reputed to be worth 
$100,000,000. 

Likewise poverty may be passed down from generation 
to generation. A special cause for handing down inequal- 



OPULENCE AND POVERTY 401 

ity of fortunes lies in the reduction of the birth rate among 
the rich. As we have explained, the tendency to-day is 
for the poor to have a high birth rate, and for the rich to 
have a low birth rate. There results a tendency toward an 
increase in the numbers of the poor and a decrease in the 
numbers of the rich. This result tends to exaggerate the 
differences in the per capita wealth between the two classes, 
for in the upper classes there will be an increasingly larger 
share for the few who inherit fortunes, and in the lower 
classes there will be an increasingly smaller share for the 
many. We see, then, that there is at least a tendency for the ^ 
rich to grow richer and the poor to grow poorer. We may 
even go so far as to say that the richer a man or family 
becomes, the easier it is to grow richer, and that the poorer 
a family becomes, the more difhcult is it to keep from 
growing poorer. Large fortunes often grow without effort. 
All that is necessary is for their owners to refrain from 
squandering. On the other hand, a family once caught in 
poverty is apt to be drawn deeper into the mire. Overwork, 
anxiety, and unsanitary surroundings bring on disease or 
disabihty, which robs them of what little they once had. 
The opportunity of the wealthy is their wealth, and the 
curse of the poor is their poverty. '^ To him that hath ,. 
shall be given, and from him that hath not shall be taken 
away even that which he hath." 

§ 7. The Limits of Enrichment and Impoverishment 

. .Yet there are limits to enrichment and impoverishment. 
The ordinary downward limit is reached with the loss of 
all capital except the human person itself. When a man has 
succeeded in losing all his capital except his own person, 
the process usually comes to an end, because society, in 
self-protection, decrees that it shall go no farther. But 
where there is no such safeguard, the unfortunate victim 
may sink into even lower stages of debt servitude, as in the 



402 ELEMENTS OE ECONOMIC SCIENCE 

Malay Archipelago or Russia, and to some extent in Ire- 
land; or they may even sell themselves or their families 
into slavery. In most countries the poor come to be a large 
and permanent as well as a helpless class. 

Next, as to the upper limit. We have seen that the 
opportunity to increase one's wealth depends upon the 
market for present and future goods, that is, the loan 
and investment market. A hermit cannot become im- 
mensely wealthy ; nor can any of the inhabitants of a small 
island, if cut off from the rest of the world. The utmost 
that a man in an isolated community can own is the capital 
which that community has or can get — its land, dwellings, 
means of locomotion, and manufacture, etc. These are 
necessarily limited by the size of the community. As the 
market widens, the limits to the growth of large fortunes 
widens also. To-day there is no limit to what one man 
may accumulate except that he cannot more than " own 
the earth." 

This relationship between the possible size of individual 
fortunes and the size of the market to which the owner of 
the fortunes has access is important. Practically it means 
that in these modern times, when almost the whole world 
is one great market, the possibihties of individual fortunes 
are greater than ever before. Few people realize this fact ; 
for most people imagine that at any time in the world's 
history any fortune " could increase at compound interest." 
But a fortune is capital value, and, as we have seen, capital 
value has no power to produce incbme, but, on the contrary, 
is merely the discounted value of anticipated income. 
The only way a man's fortune can increase at compound 
interest is by his constantly reinvesting income as it comeS 
in ; that is, exchanging it for other and later income at 
the discounted values of the latter. But evidently he must 
find sellers of some such other and later income before he 
can buy it, and he must find purchasers of the income which 
he would fain sell. His income has no power whatever of 



OPULENCE AND POVERTl^^ 403 

itself to create other income. The only way to reinvest 
his income is to find a market for it, and one in which other 
and later income is for sale. In short, an extreme upper 
limit to the growth of any individual fortune is set by the 
scarcity of investments. 

The common idea that " money has power to breed 
money " leads to absurdity when applied to compound 
interest. Were it true, any person might leave fortunes to 
posterity far exceeding the possible wealth which this 
earth can hold. The prodigious figures which result from 
reckoning compound interest always surprise those who 
make the computation for the first time. One dollar put at 
compound interest at 4 per cent would amount in one 
century to $50, in a second century to $2500, in a third 
century to $125,000, in a fourth century to $6,000,000, in 
a fifth century to $300,000,000, in a sixth century to 15 
bilKons, in a seventh century to 750 billions, in an eighth 
century to 40 trilHons, in a ninth to 2 quadrillions, and in a 
thousand years to 100 quadrillion dollars. Now the total 
capital in the United States is only about 100 billions, and 
that in the world at large — even assuming that the per 
capita wealth elsewhere is as large as the United States, 
which is an absurdly large allowance — would be less than 
2 trillions, which is only one fifty- thousandth part of what 
we have just calculated as the amount at compound interest 
of $1 in 1000 years. Yet 1000 years is only half the time 
since the Christian era began. In 2000 years the $1 would 
amount to 100 quadrillion times 100 quadrillion, which is 
many, many times as much as a world composed of solid 
gold. Needless to say, such a prodigious increase of wealth 
could never actually take place, for the simple reason that 
this is a finite world. The difficulty hes, not simply in the 
reluctance of people to provide for accumulation several 
centuries after their death, but also to the fact that large 
accumulations would reduce the rate of interest. The 
attempt, for instance, to invest trilHons every year would 



404 ELEMENTS OF ECONOMIC SCIENCE 

drive up the prices of all investible property, i.e. all capital. 
To invest such sums would practically require the pur- 
chase by the rich man of all existing railways, steamships, 
factories, lands, dwellings, etc. But many of the present 
owners of these, having already sold a good deal and thus 
reduced their rates of impatience to equahty with the pre- 
vaihng rate of interest, would not part with more except at 
prices so high that the purchaser would make little or no 
profit or interest on his investment. Thus, the approach 
toward the limit of investment would reduce the rate of 
interest and retard, and finally altogether prevent, further 
accumulation. 

There are a few examples of long-continued reinvest- 
ments. Benjamin Franklin at his death, in 1790, left £1000 
to the town of Boston and the same sum to Philadelphia, 
with the proviso that it should accumulate for a hundred 
years, at the end of which time he calculated that at 5 per 
cent it would amount to £131,000. In the case of the 
Boston gift, it actually amounted, at the end of the cen- 
tury, to $400,000, and has since accumulated to about 
$600,000. The sum received by the city of Philadelphia 
has not increased nearly so fast. 

Another interesting case of accumulation is that of the 
Lowell Institute in Boston, which was founded by a be- 
quest of $200,000 in 1838, with the condition that 10 per 
cent of the income from it should be reinvested and added to 
the principal. A peculiarity of this provision is that it 
applies in perpetuity. There is, therefore, theoretically, 
no limit to the future accumulation thus made possible. 
The fund, after only 67 years, amounts already to $i,icr , ooo. 

§ 8. The Cycle of Wealth 

With a world market for investment, we have every pros- 
pect of a great increase in private fortunes in the next few 
centuries. But practically the limit reached in the history 



OPULENCE AND POVERTY 405 

of most large fortunes is only a very small part of the high 
limit we have set, that of '^ owning the earth." There is 
usually a reaction against the desire to accumulate. Each . 
reduction in the rate of interest tends to check the desire ' 
to accumulate. Moreover, this desire soon palls. A 
multimillionaire recently left his fortune to accumulate 
until 21 years after the death of his youngest heir with the 
intention of accumulating by that time the largest fortune 
on record. But his heirs much preferred to use it during 
their own lifetime, and succeeded in breaking the will. 
Even had they not succeeded, those who finally came into 
the fortune would probably have begun, at least in a few 
generations, to dissipate it. The effect of great wealth is f 
to produce habits of spending. 

It has already been noted that one's rate of preference 
for present over future income, given a certain income 
stream, will be high or low according to the past habits of 
the individual. If he has been accustomed to simple and 
inexpensive ways, he finds it fairly easy to save and ulti- 
mately accumulate a little property. The habits of thrift, 
being transmitted to the next generation, result in still 
further accumulation, until, in the case of some of the de- 
scendants, afHuence or great wealth may result. But if a 
man has been brought up in the lap of luxury, he will have a 
keener desire for present enjoyment than if he had been 
accustomed to the simple living of the poor. The effect 
of this factor is that the children of the rich, who have been 
accustomed to luxurious living, and who have inherited 
only a fraction of their parents' means, will, in attempt- 
ing to keep up the former pace, be compelled to check 
the accumulation and even to start the opposite process 
of the dissipation of their family fortune. In the next 
generation this reverse movement is likely to gather 
headway and to continue until, with the gradual subdivi- 
sion of the fortune and the increasing reluctance of the 
successive generations to curtail their expenses, in the 



4o6 ELEMENTS OE ECONOMIC SCIENCE 

third and fourth generation there comes a return to actual 
poverty. 

Wealth is usually inherited in the United States in amounts 
equal for all the heirs, so that a fortune of $10,000,000, for 
instance, if left to 10 children, will be divided in amounts of 
$1,000,000 apiece. That being the case, the fortune will 
reduce itself to -^j^^ per capita. Now, the children of the 
multimilhonaire, who dies leaving a fortune of $10,000,000 
to 10 children, each receiving $1,000,000, will probably 
have handed down to them a taste or habit for spending 
which will make them belong to the class of spenders rather 
than savers. They have been brought up in a family which 
has spent the income from $10,000,000, and each one now 
finds that he is left with the income from only $1,000,000, 
which is far less than he has been accustomed to see used 
by his parents. Trying to keep up the standards of the 
family in which he was reared, unless he happens to have 
the necessary thrift, abihty, industry, luck, or fraud to add 
to the $1,000,000, the result will be that his fortune will 
diminish. One generation after another will reduce the 
original fortune to diminishing fragments until there is 
nothing of it left. And then the unfavorable effects of 
luxury begin. A few years ago an English physician came 
to this country who had inherited a large fortune; but 
he had also inherited the desire to indulge himself in the 
present to the full extent of his capacity. As a result of 
this desire, his parents, in leaving their wealth to him, had 
left him only the income "in trust" (and it is not an 
unusual thing in England, where there are spendthrift sons, 
to leave property so that they may be able to use only the 
income). Nevertheless, this man contrived, by chattel 
mortgages and in other ways, to spend a good deal more 
than his standard income, and he was always in debt and 
in trouble. The result of such ways is sooner or later what 
is called a " shabby genteel " class. Eventually people in 
this class will have to overcome their pride, go to work, 



OPULENCE AND POVERTY 407 

and become laborers — and often common laborers. Their 
wealth-holding ancestry is forgotten. 

Thus the hmits to the possible growth of large fortunes 
set by scarcity of investments is always far higher than 
the vast majority of fortunes ever approach. Most for- • 
tunes rise and then fall, the turning point being due to the 
abandonment of thrift and the substitution of thriftlessness 
which the fortune itself sooner or later engenders. An old 
adage has put this observation in the form, " From shirt 
sleeves to shirt sleeves in four generations." We have no 
inheritors to-day to the fortune of Croesus, who, in his day, 
was supposed to be a wealthier man than Rockefeller, not 
only in proportion to the wealth of his time, but absolutely. 
A man with a start of that kind ought to have been able to 
make the fortune increase rather than decrease with the 
future, and yet we know of no heirs to that fortune. To- 
day we have a large number of wealthy famihes in this 
country, but most of them are only one generation old! 
Thus the very rich famihes, so far from growing rich indefi- 
nitely, usually do not even continue more than a few genera- 
tions rich, but grow poor, arriving, too, at the condition of 
poverty without the vitality or the character necessary to 
retrieve their lost fortunes. 

Likewise at the opposite extreme, it does not always hap- 
pen that the poor grow poorer or even remain poor. Just 
as wealth relaxes thrift, poverty stimulates thrift. The 
children of the poor often become fired with ambition to 
get on in the world simply because they are poor. These 
people often rise from the ranks, and rise rapidly. It 
should be noted, however, that unhke the downward moment | 
of large fortunes — this upward movement is the exception, | 
not the rule. It may be that 90 per cent of large fortunes 1 
pass their maximim and dechne, but only i or 2 per cent / 
of the poor pass their minimum and rise. Many fall into f 
pauperism or die. The vast majority simply remain poor. 
We see, then, that while it is very easy for those who have 



408 ELEMENTS OF ECONOMIC SCIENCE 

once reached the top of the economic strata to stay at the 
top, this seldom happens chiefly because of their conver- 
sion from savers to spenders ; and while reversely it is very 
easy for those who once reach the bottom to stay at the 
bottom, they do not always do so, chiefly because of their 
conversion from spenders to savers. 

§ 9. The Actual State of Distribution 

The resultant churning up of society neutralizes the 
tendency we have mentioned for the rich to grow richer and 
the poor to grow poorer and, what is more important, it 
prevents — to some extent — the establishment of wealth- 
castes by changing the personnel of wealth and poverty. 
The individuals of society are hke goldfish in an aquarium. 
Those once started upward continue to ascend for a time, 
when they start down again. Those once started down- 
ward continue to descend until perhaps they reach the 
bottom, when they (may) start up again. To complete the 
figure, we must suppose the shape of the aquarium to be 
like a bell, very small at the top and very large at the bot- 
tom. There is room for only a few at the top, and the 
struggle of many to get there makes it difficult for any, 
while it makes it easy for all to descend. There is the 
most room at the bottom, and consequently there is less 
change there than anywhere else. Reversely, at the top 
there is most change. The constant changing of position 
in this bell jar, while of great moment to the individual, 
does not greatly affect the distribution of society as a whole. 
There will always be about the same proportion of fish at 
each successive stratum. Professor Pare to has, in fact, 
represented the distribution of wealth by a bell-shaped 
figure which he calls the social pyramid. This is shown in 
Figure 48. The number of people having an income be- 
tween Oa and Oh is represented by the volume comprised 
in the bell-shaped figure between the plane of a a" and the 



OPULENCE AND POVERTY 



409 



plane of h'h" . The social pyramid represents the fact that 
the larger the size of a fortune the smaller the number of 
people who have it. The breadth of the pyramid represents 
the number of people who have no capital except their own 
persons. As the capital rises in amount, we find we have 
fewer and fewer people. We have no exact statistics for 
this country, but a rough popular estimate states that 
over half of our population have incomes of less than $600, 
and of the remaining half about half, enjoy incomes between 
$600 and $1200, and the other half incomes over $1200. 




The frequency of changes in fortunes, whether up or 
down, will differ greatly in different countries according to 
their age, and their laws and customs. Among these fac- 
tors the laws and customs as to wills is of great importance. 
If there is an equal distribution among the children of the 
rich, the fortune is pretty sure to run itself out in a few 
generations or centuries, but in England this result is 
prevented by giving to the oldest son the bulk of the 
estate and cutting everybody else off with small stipends. 
The idea in this case is to maintain the family dignity and 
pride, and the integrity of the large estate. In this country 



4IO ELEMENTS OE ECONOMIC SCIENCE 

there are signs that we are gradually changing toward this 
Enghsh custom by which a rich man, instead of dividing his 
fortune evenly, leaves the bulk of it to one of his heirs. 
By such a change in the custom of wilhng property there 
will be a new and powerful tendency for existing inequahties 
of wealth to be accentuated and perpetuated. 

§ lo. The Problem of Wills 

One of the special problems connected with wills is the 
problem of the extent of control a man should be allowed 
to exercise after he has died. This problem has frequently 
been under discussion. It is sometimes called the problem 
of " the dead hand." The " statutes of mortmain " in 
England grew out of this problem; also the common law 
rule that no testator can '' tie up " his estate beyond " Uves 
in being " at the time of his death plus 21 years. This rule 
apphes, however, only to so-called " private " bequests. 
To escape its operation and perpetuate his fortune a rich 
man very often leaves it to some " charitable " foimdation. 
But as it is ill advised to leave a fortune in the hands of 
persons for a number of generations, so it has been found 
ill advised to leave fortunes in perpetuity in any shape. 
For the result is that after a few generations it is impossible 
to carry out the instructions of the donor without doing harm 
— however good his intentions. Conditions will have come 
about which the donor could not foresee or provide for. In 
Norwich, England, for instance, there was left many gene- 
rations ago a small sum to support a preacher for the Wal- 
loons, who should utter a sermon in Low Dutch every year 
at a certain time. That provision is still carried out, 
although there are no longer any Low Dutch in this place. 
There is no one to understand the sermon, and yet it is 
preached every year. Recently the preacher has learned 
a sermon by heart and repeats it every year in order to 
receive his remuneration. 



OPULENCE AND POVERTY 41I 

A few years ago a lady died in England and left a fortune 
to be used for the teaching of the doctrines of Joanna South- 
gate. This woman died in 1862. Now Joanna Southgate 
had had a large religious following in England, but at this 
time there was not a single soul in England who believed in 
her doctrines. We had the curious spectacle, therefore, of 
a fortune being left in the hands of trustees, no one of whom 
could be found who beheved in these doctrines. In 1587 a 
certain man died leaving to the almshouse of Suffolk some 
real estate the income of which was then £113. The income 
at present is £3600 and the trustees do not know what to 
do with it. The result has been to make the almshouse a 
mecca for all poor people for miles around and to pauperize 
the neighborhood. 

The custom of making wills is one that is handed down 
to us from the Roman days. There were no laws in an- 
cient Germany, no laws in the Levitical laws of the Jews, 
none among the Hindus, and only slight traces among the 
ancient Greeks, regarding wills. When we talk of the sacred- 
ness of private property and the right to dispose of it by 
will, we are merely expressing our loyalty to the particular 
custom under which we happen to live. 

It may be in the future that a remedy for some of the 
present evils connected with the ownership of wealth may 
be found by limiting or regulating the inheritance of wealth 
as to time or amount ; by inheritance taxes, by limiting 
private ownership in certain perpetuities, by substituting 
leaseholds for perpetual franchises or for " fee simples " 
in mineral lands or even in all lands. There is much to be 
said on both sides of these proposals, but it is no part of 
our present task to enter upon their discussion. 



■■'? 



CHAPTER XXVI 

WEALTH AND WELFARE 

§ I. True and Market Worths 

An often-quoted passage from the Bible states that 
" the love of money is the root of all evil." Another states, 
"it is easier for a camel to go through the needle's eye 
than for a rich man to enter into the kingdom of heaven." 
On the other hand, poverty has always been regarded as 
an evil. Agur prayed that he should be given neither 
riches nor poverty. This is the theory of the golden mean. 
Still another view is that while, absolutely, wealth is good 
and the more of it per capita the better, yet its unequal 
distribution is an evil. This is the view of the socialists. 

In all these views there is some truth. Extreme wealth 
and extreme poverty are alike evils, and the disparity be- 
tween the extremes is also an evil. Moreover, besides these 
evils dependent on the quantities of wealth are other evils 
depend-ent on the qualities of wealth. But how can it be 
that wealth, which is merely the physical means for satis- 
fying human wants, can ever do harm? We have escaped 
this question hitherto because we have accepted wealth, 
so to speak, at its market valuation. As was explained at 
the outset, prices are determined by the actual desires of 
men, and, when seeking to explain prices as they are, it 
was no part of our task to inquire as to whether the desires 
which explain them are foohsh or wise, good or bad, desires. 
There was no need to distinguish between the desires which 
fix the prices of bibles and those which fix the prices of ob- 

412 



WEALTH AND WELFARE 413 

scene literature. We now propose to go a little deeper 
and to point out instances in which desirability is not in- 
trinsic utility, and in general to point out the various ways 
in which market valuations fail to give a true picture of 
actual worth. 

In the first place, as we have seen, market valuations of 
fortunes do not even show their comparative desirabilities 
because of the wide differences between the marginal desira- 
bilities of money of different people. As already pointed 
out, the marginal desirability of money decreases rapidly 
with an increase of wealth, so that — beyond a comfortable 
competence — the addition of millions means Httle that is 
really desirable. In fact, to some men Hke Mr. Carnegie 
swollen fortunes become a burden and responsibility rather 
than an addition to personal gratification. In other 
words, the desirability of opulence is small. 

§ 2. Evils connected with the Quantity of Wealth 

That extreme poverty is an evil needs no proof. We 
shall, therefore, not discuss the problem of poverty. The 
chief causes of poverty we have already shown, and its 
remedies Ue beyond the scope of our discussion. Suffice it 
to say that the problem is the greatest of all practical 
economic problems and is justly claiming a large share of 
the attention of philanthropists and reformers. Among 
the remedies or partial remedies suggested are socialism, 
old-age pensions, compulsory workmen's insurance, regu- 
lation of hours of labor, better housing, abolition of disease, 
education in thrift, profit-sharing, cooperation, monopo- 
Hzation and regulation of labor by trade unions. 

At the opposite extreme lie the opposite dangers and 
evils of great wealth. If the poor are too hard working, 
the rich are too idle. If the poor are underfed, the rich are 
overfed. If the poor have the discomforts of squalor and 
shabbiness, the rich have the discomforts of excessive style. 



414 ELEMENTS OE ECONOMIC SCIENCE 

If the poor suffer from scanty clothing, the rich suffer 
from tight lacing and high-heeled shoes. If the poor suffer 
from overcrowding, the rich suffer from the burden of over- 
grown establishments. If the poor drink alcohohcs to get 
rid of fatigue, the rich also drink to get rid of ennui. 

Not only each extreme has its evils and dangers, but 
unequal distribution of wealth has evils and dangers. One 
of these is the perverted use of great wealth in a manner to 
humihate, degrade, or demorahze the poor. Unequal dis- 
tribution of wealth produces a caste feehng, breeding con- 
tempt for the poor by the rich, and envy of the rich by the 
poor. Corresponding to differences in wealth grow up 
differences in the mode of hving, education, language, and 
manners, differences which distinguish the *' gentleman " 
and " lady " from the common herd, and which gradually 
become confused with innate differences, which are quite 
another matter. Aristocracies are almost always founded 
on wealth and are therefore almost always on a false basis. 
There are undoubtedly wide differences between men. 
If so-called aristocrats were really all the name would im- 
ply, the '' best " in body, mind, and heart, much could be 
said in favor of their segregation from the '' vulgar " crowd, 
and the developmxcnt from them of a better race of men. 
But a plutocratic aristocracy is based, not on what men are 
in themselves, but on what they possess outside of themselves. 

Because of the differences in wealth, the poor serve the 
rich. The relation of master and servant is not simply a 
commercial relation. It also represents a supposed differ- 
ence in caste. 

Probably the worst demoralization of the poor, growing 
out of inequahties of wealth, is the prostitution of the 
daughters of the poor for the sons of the rich. All students 
of prostitution are agreed that it rests on this economic 
basis. For the white-slave traffic most people are blaming 
those who engage in it, just as for drunkenness most people 
blame the saloon keeper. Doubtless these agents have 



WEALTH AND WELFARE 415 

their share of moral responsibihty. Yet they are merely 
the brokers in the business. The demand and supply are 
the important factors, and the demand and supply arise 
chiefly because of the unequal distribution of wealth. 

Next to the poor selhng their souls comes selHng their 
votes. Bribery and poKtical corruption are largely due to 
differences in wealth. In a democracy we have the ideal 
conditions for such perverted uses of wealth. In a democ- 
racy there are two great powers, the power of the ballot 
and the power of the'^purse. The power of the ballot rests 
with the poor because of their numbers. The power of 
the purse rests with the rich. Nothing could be more nat- 
ural than that the unscrupulous representatives of these 
two powers should contrive to get together for mutual 
advantage. They need not meet directly. The perverted 
pohtician intervenes as a broker. Many of the city govern- 
ments of the United States exemphfy this condition. These 
politicians make, on the one side, a business of controlHng 
the votes of the poor, partly by bribery, partly by dispens- 
ing '' charity," and partly by activity in party organiza- 
tions ; and, on the other side, they make a business of 
" holding up " the capitahsts who want franchises for street 
railways, water, gas, electric Kght, or telegraph or special 
tariff legislation. The unscrupulous capitalist finds it ad- 
vantageous to pay toll to the pohtician, either by actual 
bribery or by stock in corporations, or by what a pohtician 
recently called " honest graft " in the form of '' tips " or in- 
side information as to the stock market, real estate transac- 
tions, etc. Similarly, in our state legislatures and even in our 
national Congress, poHticians are of this character. Some 
are avowed or secret representatives of capital or " the 
interests " ; others of voters or " the people." In this case 
the conflict between plutocracy and democracy becomes 
more direct and visible. But it always exists, and will 
continue to exist in some form unless one of the two powers 
should completely vanquish the other. 



t 



416 ELCMENTS OF EEONOMIC SCIENCE 

§ 3. Forms of Wealth Injurious to the Owner 

We have seen several of the evils, and in particular some 
of the misuses, to which wealth may be put. We can better 
understand the nature of these and other misuses if we 
reemphasize the fact that the wealth, which is commonly 
measured in money, does not include the most important 
item of wealth there is — human beings. The evils of wealth 
consist largely in an increase of external wealth at the sacri- 
fice of personal wealth — in this deeper sense of the word 
^ " personal." Emerson said " health is the first wealth." 
The founder of Christianity asked, '' What profiteth it a 
man if he gain the whole world and lose his own soul? " 
Many a millionaire would wilhngly give all his money for 
youth, health, or even freedom from pain. Many uses of 
external wealth practically injure our personal wealth. 
The injury may be physical or moral or both. It is in this 
regard especially that " satisfactions," in the economic 
sense," fails to measure real welfare. Indeed, as regards the 
body, we may classify satisfactions into self-benefiting and 
self-injurious. Many articles of wealth, though possessing 
commercial value, are really injurious to those who use 
them. In some cases the articles of wealth referred to are 
used almost exclusively by the rich, in others almost ex- 
clusively by the poor. Among examples of self -injurious 
satisfactions or uses of wealth are the consumption of food 
or the wearing of clothing or the use of dwellings injurious 
to the health, the practice of unhygienic or immoral amuse- 
ments, the use of narcotics, such as opium in China, hashish 
in India, absinthe in France, whisky in Ireland, and alco- 
holic beverages in western civiHzation generally. These 
may be called perverted uses of wealth, but they are very 
common, so common as to give commercial value by millions 
of dollars to disease-producing food factories, distilleries, 
saloons, dives, gambhng houses, low dance halls, and 
theaters, houses of prostitution, immoral and degrading 



WEALTH AND WELFARE 417 

literature. The perverted satisfactions here represented 
are capitaHzed Hke any other satisfaction. They are often 
paraded to show how weahhy a nation is, but as they 
weaken the stamina of the people and shorten their lives, 
they really lessen the satisfactions in the end. In any com- 
plete view of the subject they should be recognized as 
sources of national weakness, not strength. This is recog- 
nized in the great reform movements — housing reform, 
temperance reform, the movement to abolish the " white- 
slave " traf&c. 

§ 4. Forms of Wealth Injurious to Society 

Other evils of wealth consist in its use by one person to 
injure another. Just as we classified some satisfactions into 
personally beneficial and injurious, so other satisfactions 
may be classified into socially beneficial and injurious. 
Examples of socially injurious satisfactions are of many 
kinds. Robbery, fraud, embezzlement, arson, and other 
criminal acts are too obvious to need more than mention. 
A burglar's " jimmy " is an article of wealth to the burglar, 
but it nevertheless is a means of injury to society. 

Of less obvious examples one is the exploitation of gold 
mines when their product depreciates the currency. Except { 
so far as gold is used as an ornament, or in the arts, its pro- 
duction at a sufficiently rapid rate, tends to raise prices. 
Here we find great gold fields, stamp mills, assay and 
smelting works, etc., standing in our accounts as important 
items of national capital. Yet in the last analysis they 
are injurious, rather than beneficial, to the country. While 
they afford means and opportunities for their individual 
owners and exploiters to make great private fortunes, they i 
do not enrich a nation or the world ; for their sole effect is r 
merely to change the numbers in which prices are expressed. ^ 



Thus the labor and capital invested in gold mines may be 
said to be socially wasted. A small amount of money is 

2E 



41 8 ELEMENTS OE ECONOMIC SCIENCE 

as good a medium of exchange as a large amount. In fact, 
if the gold flows out of the gold mines fast enough to raise 
prices, the result is social harm rather than good : for it dis- 
turbs the distribution of wealth and continually tends to 
precipitate a crisis. 

The gold miner's fortune is thus made not as an addition 
to the world's real wealth, but by an abstraction from the 
world's wealth for his benefit, with secondary effects more or 
less injurious. The gold miner, as it were, robs society. 
Thus, even the most genuine gold brick, in which there is 
no thought or intent to defraud, may prove in the end an 
unconscious swindle. 

Other examples of socially injurious wealth are such nui- 
sances as the '' smoke nuisance " and " pests " of various 
kinds. A factory which defiles the household linen and 
the lungs of the neighborhood is not an unmixed bene- 
fit. If all the injury it caused could accrue to the factory 
owner, he would put in a smoke consumer, or else most wil- 
lingly sufi^er a great deduction in the value of his plant. In- 
stead, he causes a great loss of value thinly distributed over 
blackened houses and an injury never capitaKzed or meas- 
ured in the health of his fellow citizens. Such cases, where 
social interests and individual interests do not run parallel, 
justify legal interference. We cannot allow bonfires in a 
crowded city, nor freedom of movement on the part of those 
carrying infectious diseases. 

§ 5. Forms of Wealth used for Social Racing 

The other examples of socially injurious uses of wealth 
we shall mention are all cases of social rivalry. Three 
special cases will be considered. 

The first relates to warfare and the preparation for war. 
It is usually conceded that actual warfare is economically 
injurious. The best that the apologists for war can say 
is that it is inevitable. But it is not so well recognized 



WEALTH AND WELFARE ^19 

that the economic preparation for war is an example of 
world waste, albeit an effort toward economy on the part of 
each individual nation. When Germany invested millions in 
armaments, she merely stimulated France to do the same. 
They have been racing with each other ever since, as have 
other countries, including England and the TJnited States. 
Each battleship which costs $10,000,000, in the end adds 
practically nothing to the world's wealth. On the con- 
trary, as soon as a similar battleship is added to the navies 
of rival powers, the various nations are in precisely the 
same relative position as before any battleships were built 
at all. Preparation for war is a species of cutthroat 
competition. If six world powers, instead of investing 
each $10,000,000 in a battleship, should agree not to do so, 
the result would be to save $60,000,000 from being wasted. 
The case would be very different if the ships belonged to the 
merchant marine. In that case, the building of $60,000,000 
worth of ships would add that much to the world's produc- 
tive capital. The ability of merchant ships is absolute, 
that of battleships is relative. The only object in one 
nation's building a battleship is to increase its strength 
relatively to other nations. Just as soon as this move is 
met by the other nations, all the advantage which it was 
sought to gain is lost again. 

Thus, for the most part, the " capital " of nations, in the 
form of armaments, represents economic waste, although 
no one nation could afford to dispense with it as long as 
other nations do not. 

Our second example of socially injurious rivalry is com- 
mercial cutthroat competition. We have seen that what is 
often to the interests of individual producers is against the 
common interests of producers as a group. We may now 
add that it may be injurious to the interests of society as a 
whole. In fact, we have already noted that a patent and 
copyright have their justification in the fact that the play 
of unprotected individual interests would practically re- 



420 ELEMENTS OF ECONOMIC SCIENCE 

suit in discouraging or suppressing inventions and books. 
The same must often be true in many other instances. 
Telephone competition is not only injurious to the telephone 
companies but to the subscriber, who either has to have 
two or more telephones in his house, with all the expense 
and annoyance which that imphes, or has to lack proper 
and easy connection with subscribers to other systems than 
the one he employs. 

§ 6. Wealth for Vanity 

Our third example of socially injurious rivalry is perhaps 
the most important and pervasive, although the most 
subtle of all. It concerns rivalry in wealth itself, and 
introduces us to the subjects of luxury, extravagance, social 
ambition, and vanity. Thackeray's novel, " Vanity Fair," 
is a satire on the sort of economic rivalry referred to. Van- 
ity may be defined as a desire to obtain the ap- 
proval of others, and vanity leads to social rivalry. This 
may be considered as rather a broad definition of vanity, 
and it is one which does not necessarily imply any slur, 
although most desires which are desires of vanity are sub- 
ject to criticism or question. The important part played 
by vanity in economic affairs is seldom reaHzed. A case 
of pure vanity is seen when a man wants merely the badges 
of distinction. For instance, the badge of the Legion of 
Honor which Napoleon estabHshed in France is much de- 
sired, merely as a means of obtaining the approval of 
other people. It has no intrinsic desirability. It is not 
because it is beautiful that it is desired ; it is not because 
the badge can keep one warm or appease one's hunger or 
fulfill any of the primitive and individual desires of men. 
It merely appeals to the instinct to attain distinction in the 
eyes of other people. But most cases of vanity are not so 
pure, but are mixed with a substratum of actual utility. 
For instance, a diamond is desired chiefly out of motives of 



WEALTH AND WELFARE 42 1 

vanity, but it is desired also because it appeals to the aes- 
thetic sense. It is a curious fact that as soon as we mix 
vanity, with some other motive, people begin to hide behind 
this other motive and conceal the vanity of which, for some 
reason, they seem to be ashamed. When a woman wears 
a diamond hatpin, and can never, by virtue of its position, 
see it herself, what motive is there except vanity ? Of course 
it may be said that she is an altruist in attempting to pro- 
vide an article of beauty forother people to admire ; but 
the real object, however she may condone or conceal it, is 
to display this diamond to other people and to show thereby 
that she is able to possess it. Most articles of ornament 
pander chiefly to this m_ode of vanity and come into exist- 
ence largely and chiefly for this reason, although the admira- 
tion of actual beauty is a secondary element and a subter- 
fuge. 

The amusements of mankind are almost always, or to a 
large extent, mixed with the motive of vanity. For in- 
stance, automobiling to-day is not always indulged in for 
the sake of sport alone, but also for the sike of display. 
Equipages have always been one of the means of displaying 
wealth. Narcotics have always been objects desired not 
merely for their drug effect, but also for the effect of display. 
The habit of using fine wines and expensive drinks in enter- 
taining has long been one of the methods of social display. 
Clothing, even, and housing, are very often objects of 
vanity. In fact, historically, clothing originated as orna- 
ments, like jewelry, rather than as an actual protection from 
the weather. Even food is a matter of vanity to a certain 
extent. Feasts have been favorite occasions for the exer- 
cise of this instinct. 

A few extreme examples of ostentation will help us to 
understand the nature of vanity. Some yea^s ago there 
was an American in Florence who carried the idea of display 
in his equipage to the extreme of getting a chariot and 
having sixteen horses to pull him through the narrow streets 



42 2 ELEMENTS OF ECONOMIC SCIENCE 

of the city. Ordinarily an attempt to gratify vanity re- 
sults in the approval which is sought by the individual, 
but in extreme cases Hke this it often results in disapproval, 
and this man was known in Florence for years as " that 
fool American." A well-known French count, who through 
marriage became possessed of means, gratified the instincts 
of vanity by proceeding to spend untold sums in building 
a large and useless colonnade of pillars, simply to show 
that he was able to do so. A person not long ago left a 
will providing $1,000,000 for the erection of his own tomb. 
Cleopatra once showed what she could afford by drinking 
a dissolved pearl. Pliny shows that after Cleopatra did 
this she was imitated by the son of a famous actor, and 
the practice of drinking pearls became a sort of fashion 
in Rome, as to-day some men of a less subtle vanity light 
cigars with $5 bills. It was probably this practice which 
led to the phrase "money to burn." In Philadelphia not 
very long ago a lady had a carpet made with a special 
design, and when the carpet was completed she was care- 
ful to have the design destroyed lest any one else should 
have a carpet like hers. A well-known speculator is said 
to have bought for his wife for $30,000 a particular pink, 
in order that it might be called by her name. In Holland, 
centuries ago, there was a furor over tulip bulbs which 
took such a hold on the people that it led to extravagantly 
high prices for these symbols of vanity. In 1639 one bulb 
sold for what would be approximately $2000 in our money. 
Another instance is found in the admiration people have 
for foreign importations. Many people really delude 
themselves with the idea that they care for an imported 
cigar or wine because they believe the article to be superior 
to the domestic article. Nor is this the only species of 
vanity appeased by the purchase of foreign goods. An art 
dealer in San Francisco found that people there preferred 
to pay $4000 in Paris for the same picture which they could 
buy in San Francisco for $2000, in order that they might 



WEALTH AND WELFARE 423 

state that they bought it in Paris. The artists of San Fran- 
cisco found it advisable, therefore, to take their pictures to 
Paris, in order that they might get a higher price from 
Americans. Not long ago an American who lives in a well- 
known cheese-making district in New York paid a very high 
price for an imported cheese and took great delight in the 
fact that it was imported. As a matter of fact, it had first 
been exported from his own town. There is said to be a 
large industry in the exportation of cheese, the same being 
naturahzed abroad and sent back to this country and 
sold as foreign cheese. When the Enghsh tariff on French 
wines made their price higher in England than in France, 
and the French tariff on English intoxicants raised their 
price in France, the higher classes in France would consume 
the English article, and the higher classes in England would 
consume the French article, while both would not use the 
domestic article because it was too " common." 

Jewelry has always been regarded as a matter of vanity. 
If a chemical method should be developed of making a real 
diamond cheaply, the desirability of diamonds would be 
destroyed; they would immediately go out of fashion. 
The invention would be self-destructive, and the price of 
diamonds and the use of diamonds destroyed. That is, 
diamonds are desired because they are scarce and a badge 
of economic power of the people who purchase them. This 
is why imitation jewelry is regarded as a sham. Paste 
diamonds may be quite, or nearly, as beautiful as real 
diamonds, but they can never be nearly as valuable. Those 
who use them do so not because they regard them as beau- 
tiful, but usually in order to make people believe they are 
'' real " and that the possessor can afford to buy them. 
Sometimes they are worn as symbols of real diamonds kept 
for safety in bank vaults. The owners then appear at the 
opera with the imitation jewels. When spoken to of their 
jewels, these people will say that they are not real jewels, 
but are an exact imitation of real jewels which are in the 



424 ELEMENTS OF ECONOMIC SCIENCE 

safe deposit vaults. In such cases the mutation jewels 
serve purely and simply as badges of ownership. There is 
then supposed to be no pretense involved. The wearers 
would be thought '' cheating " if they possessed only the 
paste. Their virtue consists in actually having the 
" real thing," which the paste replica proclaims they can 
afford. A wealthy woman seriousty argued the question of 
whether a poor woman had a right to wear an imitation 
diamond. Her thought was that, since the poor person 
could really not afford to have a real diamond, to wear the 
imitation diamond amounted to deceit. 

§ 7. The Cost of Vanity 

Now the efforts to satisfy vanity are like international 
armaments. The chief advantage that social racing gives 
to an individual is a relative advantage. But this impHes 
that he puts other people to a relative disadvantage. The 
effect on society is to waste the cost of keeping up the race. 
This cost consists in the labor expended on the gratification 
of vanity, and shows itself in the high prices of articles for 
that purpose. The tax thus laid by society upon itself is 
enormous, and may be measured roughly by the annual pur- 
chases of articles of pure vanity. Yet people seldom com- 
plain, for the individual can see httle or no difference between 
the good he gets from an article of vanity and the good he 
gets from any other article. He does not care much about 
the pace he may be setting others, and he does not hold any 
other person responsible for the pace which has been set him. 
He looks at the world's fashions as an inevitable fact, and ad- 
justs his own actions to it. Our task, however, is to look 
at the social effects of his action on others, and of others' 
actions on him. His expenditures for vanity may give 
him the satisfaction of " climbing," but by as much as he 
gets ahead of others the others are left behind. They are 
all in a social race to get ahead. In the scramble all are at 



WEALTH AND WELFARE 425 

great effort or expense, and in the end there is a loss of eco- 
nomic power similar to the loss of nations racing for military 
supremacy. Undoubtedly the race stimulates the racers, 
and may do them some good as a mode of exercising their 
abihties, and even lead to useful inventions. The same 
maybe said of war. But our present purpose is to point out 
the cost, which is usually overlooked. If the true cost 
could be expressed in figures, it would doubtless amaze 
people who have never stopped to see the extent to which 
luxury and luxurious rivalry is carried. Almost all expendi- 
ture is more or less colored by it. 

We have compared the extravagance which is created 
by the desire of a man to compete with his neighbor van- 
ity to a race. We called it social racing. Now when 
fashion enters into the matter, as it almost always does, this 
race becomes more like a chase. There are leaders and fol- 
lowers, and the followers try always to overtake the leaders. 
When they do so, the leaders turn in their course in order 
to elude their pursuers. The consequence is that fashions 
are constantly changing at the hands of the leaders of fash- 
ion. The leaders of fashion are usually from among the 
richest people in the community, and whatever they con- 
sume, those beneath them in the social or economic scale 
wish to consume also. 

We may take, as an example, the case of russet shoes, 
which are constantly coming in and going out of fashion. 
A few years ago a gentleman was surprised to find that 
only the highest grades of russet shoes were carried on the 
market. When he asked the reason, he was told that russet 
shoes had gone out of fashion only a year or two before; 
that now they were coming in, and the only way by which 
they could be got in was by putting the highest grades on 
the market first, because if the lowest and cheapest grades 
were put on, then the leaders of fashion would not want 
them, and if the leaders did not want them, then followers 
would not want them either. After this initiatory demand 



426 ELEMENTS OF ECONOMIC SCIENCE 

has been satisfied, the shoes are imitated in cheaper grades, 
until finally russet shoes become so common that the lead- 
ers refuse to wear them longer and they go out of fashion — 
only to come back again in a few years, after which the same 
cycle is repeated. 

One result of this constant search for inequahty is often 
a pretended inequality. Consequently this constant social 
rivalry puts society on more or less of a false basis. There 
is a pretended inequahty and an effort on the part of the 
so-called upper classes to assert a superiority, even in blood, 
over the so-called lower classes. It leads, in other words, 
to snobbishness and the caste system. 

Vanity is literally insatiable. Without vanity there 
would be little use for the fortunes of multimilHonaires. 
Beyond a modest fortune more money would be to them 
entirely superfluous. Therefore the use to which they put 
their millions is of much more moment to society than to 
themselves. If they use it to set standards of luxury, they 
are using it in a socially injurious manner. They produce 
the same effect on society as though they levied a tax on 
aU persons poorer than themselves. 

§ 8. Remedies for the Evils of Vanity 

We have seen that the natural remedy for cutthroat 
competition in business is combination. In the same way 
if there could be a general " disarmament," as it were, or 
agreement between the social competitors, it might solve 
the problem of social racing. 

This indeed has been done on a small scale in schools, 
colleges, and clubs. A good instance is among women's 
sewing circles. When such a circle is first organized, the 
hostess gives a very simple entertainment. At the next 
meeting a rival hostess gives something a Httle more elabor- 
ate and presently the members of the circle are madly racing 
in the effort to supply the best entertainment. A reaction 



WEALTH AND WELFARE 427 

becomes necessary and the ladies finally agree explicitly, 
" not to serve more than two kinds of cake." 

An example of how this general disarmament works was 
seen in San Francisco at the time of the earthquake. There 
the people who Hved formerly on Nobb Hill in fine houses 
had to Hve in tents or out of doors. So far as this loss was 
concerned, it was no loss at all, at first at any rate, because 
each man was perfectly willing and Hked to live out of doors, 
providing his neighbor lived the same way. But before the 
earthquake any one of these people would have been 
ashamed to live in a tent because he knew that his neighbors 
would wonder why he did not live in a house as good as theirs. 

Very similar to social disarmament, is compulsion by 
the government. The Dutch government finally took 
a hand in the tuhp-bulb craze because it was so heavy 
and foolish a tax on the national resources, and the traffic 
in bulbs was stopped. History contains many examples 
of sumptuary laws designed to check social racing. 

One cure has been suggested by John Rae which is 
ingenious, although it has never been consciously put into 
use. He says, and wisely, that we cannot change this in- 
herent ambition in human nature. All we can do is to turn 
it to some good account instead of letting it run to waste. 
He suggested that social racing could be made to yield a 
revenue to a government by taxing imported luxuries so as 
them expensive and therefore desired by the wealthy and 
their imitators. A case in point is that of the cheap wines 
of France being dear in England because of the tariff and 
cost of importation across the channel, and reversely, the 
cheap wines in England being dear in France. Each was 
fashionable in the country of the other. Now if a tax is 
able to create a fashion in this way, through making an 
article exclusive, the government gets a revenue by creating 
a fashion, so to speak, by making certain imported goods 
so rare that they become sought after as matters of fashion, 
so that the tax imposed on society by fashion is made to 
accrue to the government. 



428 ELEMENTS OF ECONOMIC SCIENCE 

Another way is to change the fashion of fashion, so to 
speak, so that it may run into useful instead of useless rivalry. 
One of the better forms of vanity does not satisfy itself 
by display in the usual sense, but seeks to make a record 
of power in the financial world. In these days a man may 
advertise his wealth in other ways than high Uving. To be 
known as the largest stockholder in a railway is a dis- 
tinction coveted by men. In fact, in spite of many 
evidences to the contrary, there are some indications that 
display, in the old sense, is decreasing, especially among 
men. To-day men seldom wear jewelry or gaudy clothing. 
""Business distinction takes the place of these. Even women 
are becoming ambitious to lead in other ways than 
" society." They seek distinction at women's clubs or as 
executives in charitable effort. There is, as a matter of 
fact, no reason why rich men and women should not try 
to distinguish themselves by doing good, and the tendency 
in America to-day is exactly in this line. Rich men are 
gradually trpng to distinguish themselves by their large 
benefactions instead of by their large expenditures. They 
create great philanthropic foundations and endow hospitals, 
sanitariams, libraries, and universities. 

A few years ago, in the city of Pittsburg, two wealthy 
men vied with each other in attempting to display 
fine buildings for the good of the city of Pittsburg, and one, 
in order to triumph over his neighbor, who had put up 
imposing buildings in one square, purchased the square 
immediately adjacent at a very exorbitant price for the 
purpose of erecting a still finer building for the use of 
the city of Pittsburg. 

Social racing of this sort may be socially beneficial and 
is an encouraging sign of the times. At present, however, 
great wealth is as a rule either running to waste or taxing 
those who cannot keep up with it. Perhaps some day it 
may — like other great wastes — be caught and harnessed 
and made to do some of the world's work. 



One copy del. to Cat. Div. 



